Tax havens and their use by United States taxpayers : an overview : a report to the Commissioner of Internal Revenue, the Assistant Attorney General (Tax Division) and the Assistant Secretary of the Treasury (Tax Policy)

UNITED STATES TAXPAYERS
- AN OVERVIEW

JANUARY 12, 1981

LIBRARY

ROOM 5030

»UG 1 « 1986
TREASURY DEPARTMENT

Tax Havens and
Their Use By
United States Taxpayers
-An Overview

A report to the

Commissioner of Internal Revenue

the
Assistant Attorney General (Tax Division)

and the
Assistant Secretary of the Treasury (Tax Policy)

Submitted by:
Richard A. Gordon
Special Counsel for
International Taxation

January 12, 1981

Publication 1150 (4-81)

COMMISSIONER OF INTERNAL REVENUE
Washington. DC 20224

January 13, 1980

Mr. William E. Williams
Acting Commissioner
Internal Revenue Service
Room 3034,
Washington, D.C. 20224

Mr. M. Carr Ferguson
Assistant Attorney General
Department of Justice
Room 4143
Washington, D.C. 20530

Mr. Donald C. Lubick

Assistant Secretary (Tax Policy)

Main Treasury

Room 3112

Washington, D.C. 20220

Dear Sirs:

You have asked that I review and advise you regarding

the use of tax havens by United States persons and present

options to be considered for dealing with problems created
by that use.

In response to your request, I am pleased to submit the
enclosed report which is based on a study and analysis of
tax haven transactions, United States internal tax laws
applicable thereto. United States income tax treaties, and
the attempts of the tax administrators to deal with these
transactions.

Richard A. Gordon
Special Counsel for

International Taxation

Enclosure

Department of the Treasury Internal Revenue Service

T TAX HAVENS AND THEIR USE BY

UNITED STATES TAXPAYERS - AN OVERVIEW

A REPORT TO

THE COMMISSIONER OF INTERNAL REVENUE

THE ASSISTANT ATTORNEY GENERAL (TAX DIVISION)

AND

THE ASSISTANT SECRETARY
OF THE TREASURY (TAX POLICY)

Submitted by:

Richard A. Gordon January 12, 1981

Special Counsel for

International Taxation

TAX HAVENS AND THEIR USE BY UNITED STATES TAXPAYERS

AN OVERVIEW

Summary of Contents

Introduction 1

I. Overview of Findings and Recommendations 3

II. Tax Havens - In General 14

III. Statistical Data on Patterns of Use of Tax Havens 32

IV. united States Taxation of International Transactions
and the Anti-Avoidance Provisions - An Overview 42

V. Patterns of Use of Tax Havens.. 59

VI. Use of Tax Havens to Facilitate Evasion of U.S. Taxes. Ill

VII. Options for Changes in Substantive Rules 128

VIII. Treaties with Tax Havens 147

IX. Information Gathering 180

X. Administration 217

TAX HAVENS AND THEIR USE BY UNITED STATES TAXPAYERS "

AN OVERVIEW

Table of Contents

Introduction. 1

I. Overview of Findings and Options 3

II. Tax Havens - In General 14

A. Characteristics 14

1 . low Tax 15

2. Secrecy 15

3. Relative Importance of Banking 17

4. Availability of Modern Communications 19

5. Lack of Currency Controls 19

6. Self Promotion - Tax Aggression 19

7. Special Situations - Tax Treaties 20

B. Background 20

1. Historical Background 20

2. Modern Background 21

3. Present Situation 22

C. Reasons for Use of Tax Havens 22

D. Foreign Measures Against Tax Havens 24

1. Unilateral Approaches 24

a. Tax Legislation 24

(i) Provisions similar to subpart F 24

(ii) Transfer pricing 26

(iii) Transfers of property abroad 26

(iv) Provisions relating to deductions 27

(v) Expatriation 27

(vi) Special provisions 28

b. Non-Tax Measures 29

c. Effectiveness 29

2. Multilateral Approaches 30

III. Statistical Data on Patterns of Use of Tax Havens 32

A. Levels of Use by U.S. Persons Through Tax Haven
Companies 33

B. Levels of Use by Foreign Persons 34

C. Levels of Use by Banks 35

D. Levels of Use by Tax Evaders 36

IV. United States Taxation of International Transactions

and the Anti-Avoidance Provisions - An Overview 42

A. Policy Objectives 42

B. Basic Pattern 46

1. General Rules 46

2. United States Taxation of Property Held by

a Foreign Trustee 49

3. Taxation of Corporations and Their Share-
holders 50

- 11 -

C. Anti-Abuse Measures 51

1. Accumulated earnings tax 51

2. Transfer pricing 52

3. Sections 367 and 1491 52

4. Personal holding companies 54

5. Foreign personal holding companies 54

6. Section 269 55

7. Foreign investment companies 55

8. Controlled foreign corporations 56

9. Dispositions of stock of controlled foreign
corporations 58

10. Dispositions of patents to foreign cor-
porations 58

V. Patterns of Use of Tax Havens 59

A. Tax Avoidance v. Tax Evasion 59

B. Transfers to a Tax Haven Entity 61

1. Transfer Pricing 62

2. Transfers of Assets Other than by Transfer
Pricing 63

a. Transfers to Tax Haven Corporations — Scope

of §3 67 63

b. Transfers Not Reorganizations 66

C. Transactions Through a Controlled Entity 68

1. Tax Planning — Minimizing Tax and Maximizing

the Foreign Tax Credit 69

2. Holding Companies 72

3. Sales Activities 74

4. Services and Construction 79

5. Transportation 84

6. Insurance 86

7. Banking 90

D. Transactions Through an Entity which is not
Controlled 91

E. Principal Patterns of Abusive Tax Haven Use
Predominently by Promoters and by Individual
Taxpayers 94

1. Background 95

2. Patterns of Use 95

a. Investment Companies 95

b. Trading Company 96

c. Holding Companies 97

d. Shelters 97

( i ) Commodities 98

(ii) Movies 100

(iii) Foreign situs property 101

e. Foreign Trusts 101

f. Double Trusts 104

g. Generating Deductions 105

h. Expatriation 106

- Ill -

F. Use by Foreign Persons Doing Business in or

Residing in the U.S 107

1. Banks 107

2. Insurance 108

3. Entertainment Industry 109

4. Trading and Sales Companies 109

5. Aliens Resident in the U.S 109

VI. Use of Tax Havens to Facilitate Evasion of U.S. Taxes.... Ill

A. Prior Efforts to Investigate Offshore Cases 112

B. Narcotics Related Cases 116

C. Patterns of Use of Tax Havens for Evasion 118

1. Double Trusts 118

2. Secret Bank Accounts 119

3. U.S. Taxpayers Using a Foreign Corporation -
Substance over Form 120

4. Shelters - Commodity Transactions 121

5. Income Generated Overseas Deposited in a
Foreign Bank Account 122

6. Slush Funds 123

7. Use of a Foreign Entity to Step-up the Basis

of U.S. Property 123

8. Repatriation of Funds 123

D. Informants and Undercover Operations 124

E. Analysis 127

VII. Options for Change in Substantive Rules 128

A. Options Which Can be Accomplished Administratively. . 128

1. Burden of Proof 128

2. Section 482 Regulations 129

3. Subpart F Regulations 132

4. Application of §269 and the Accumulated Earnings
Tax 133

5. Review Rev. Rul. 54-140 133

6. Revocation of Acquiescence in CCA, Inc. 134

7. Captive Insurance Companies 134

8. Income of Foreign Banks 134

B. Options Requiring legislation 135

1. Expansion of Subpart F to Target it on Tax

Haven Entities 135

2. Adoption of a Management and Control Test for
Asserting U.S. Taxing Jurisdiction over Foreign
Corporations 138

3. Change in Control Test 139

4. Service and Construction Income 140

5. Merger of the Foreign Personal Holding Company
Provisions into Subpart F 141

6. Captive Insurance 143

7. Shipping Income 143

8. De minimus Exclusion from Foreign Base Company
Income 143

9. Commodity Shelters 143

- IV -

10. Tax Haven Deductions 144

11. No Fault Penalty 145

12. Foreign Trusts 145

13. Expatriation 146

14. Residence 146

VIII. Treaties with Tax Havens 147

A. Basic Principles 147

B. Tax Haven Treaty Network 149

C. Third Country Resident Use of United States Tax
Treaties with Tax Havens 152

1. Forms of Third Country Use 152

a. Foreign borrowing 153

b. Finance companies 153

c. Holding companies 154

d. Active business 156

e. Real estate Investment 156

f. Personal service companies — artists and
athletes 157

2. Analysis of Third Country Use 157

D. Use of Treaty Network by Earners of Illegal Income

or for Evasion of United States Tax 159

1. Methods of Use 160

2. Analysis of Illegal Use 161

E. Administration of Tax Treaty Network 162

F. Options for Tax Haven Treaties 166

1. Administrative Options 167

a. Refund system of withholding 167

b. Increase audit coverage of treaty issues.. 168

c. Periodic review of treaties 168

d. Exchange of information article over-
riding bank secrecy 168

e. Improve the quality of routine infor-
mation received 169

f. Rulings 169

g. Coordination with ITC 170

2. Changes in Treaty Policy 170

a. Treaty network 170

b. Source country taxation 171

c. Anti-holding company or anti-conduit
approaches 171

d. Expansion of anti-abuse provisions to
active business 17 2

e. Second withholding tax 173

f. The insurance premium exemption 173

g. Personal service companies -- artists and
athletes 174

3. Legislative Approaches 175

a. Reduction of the rate of tax on fixed

or determinable income 175

b. Anti-treaty abuse rules 176

c. Branch profits tax 176

- V

IX. Information Gathering 180

A. Reporting 180

1. IRS Forms 181

a. Analysis 181

b. Options 184

2. Bank Secrecy Act Forms 186

a. Transactions with financial institutions. .. 186

b. Transport of currency 188

c. Foreign bank account 188

d. TECS 188

e. Analysis 189

f . Options 191

3. Penalties for Failure to File or Adequately
Complete Forms 192

a. IRS forms 192

b. Bank secrecy act forms 192

c. Options 193

B. Books and Records — Foreign Transactions — In
General 193

1. General Requirements for Maintenance of
Adequate Books and Records 194

2. Penalties for Failure to Maintain Adequate

Books and Records 194

3. Powers to Compel Production of Books and
Records 195

4. Analysis 195

a. Legal 195

b. Administrative 196

c. Tactical 196

C. Information Gathering Abroad 197

1. Unilateral Means 198

a. Public Information 198

b. Overseas Examination 200

c. Compulsory Process 201

( i ) Administrative summons 201

(ii) Judicial subpoena 204

(iii) Letters rogatory 205

d. Tax Court 206

e. Information Gathering Projects and
Informants 206

2. Bilateral and Multilateral Means 206

a. Tax treaties 207

b. Mutual assistance treaties 209

D. Options 210

1. Unilateral Actions 210

a. Asserting the taxpayer's burden of proof... 210

b. Requiring that books and records be
maintained in the U. S 211

c. Venue Where a Party Summoned is Outside

the United States 211

- VI -

d. Admissibility of foreign business records. .. 211

e. IRS review process for mutual assistance. ... 212
2. Bilateral Approaches 212

a. Mutual assistance treaties 212

b. Limited tax treaties 212

c. Bilateral exchange of information
agreements 212

d. Revise exchange of information article 213

e. Steps to isolate abusive tax havens 213

X. Administration 217

A. In General 217

1. Examination Division 217

2. Office of International Operations 218

3. Criminal Investigations 220

4. Office of the Chief Counsel 221

B. Analysis 222

1. Coordination 222

2. Coverage of Tax Haven Cases - Availability of
Expertise 225

3. Providing Technical and Legal Assistance to the
Field 227

4. Simultaneous and Industrywide Examinations 228

5. Chief Counsel 229

C. Options 229

1. Improve Coordination with Respect to Tax Haven
Issues Specifically and International Issues

in General 229

2. Increase Coverage of Tax Haven Cases 231

3. Expand Training of International Examiners to
Include Noncorporate Issues and Expand Training

of Agents in the General Program 232

4. Provide Additional Technical and Legal Expertise

to the Field 233

5. Expansion of the Simultaneous Examination Program
and the Industrywide Exchange of Information
Programs 233

6. Chief Counsel 234

TAX HAVENS AND THEIR USE BY UNITED STATES TAXPAYERS -

AN OVERVIEW

Introduction

This study was undertaken at the request of the Commissioner
of Internal Revenue, the Assistant Attorney General (Tax
Division), and the Assistant Secretary of the Treasury (Tax
Policy) .

The purpose of the study was to develop an overview of
tax havens and the use of tax havens by United States taxpayers.
The study sought to determine the frequency and nature of
tax haven transactions, identify specific types of tax haven
transactions, obtain a description of the United States and
foreign legal and regulatory environment in which tax haven
transactions are conducted, describe Internal Revenue Service
and Justice Department efforts to deal with tax haven related
transactions, and to identify interagency coordination
problems.

Our findings are based on a review of judicial decisions
and published literature in the field of international tax
planning, research into internal IRS documents concerning
taxpayer activities, interviews with IRS personnel, personnel
who deal with tax haven issues for other Federal government
agencies, and lawyers and certified public accountants who
specialize in international taxation. Our findings are
also based on a statistical analysis of available data
concerning international banking. United States direct
investment abroad, and foreign investment in the United
States. While we cannot claim that we uncovered all of the
methods employed to use tax havens, we believe that our
inquiry was extensive enough to give us an understanding of
the situation and to enable us to develop options which
might be useful in improving the administration of the tax
laws as they apply to tax havens.

The findings and recommendations of this report are
directed to six main areas:

First, identifying tax havens, the policy issues raised
by them, and the concerns of other countries;

Second, describing the patterns of use by United States
and foreign persons and presenting options for curbing that
use should that be desired;

Third, describing patterns of use to evade united
States taxes;

Fourth, describing the impact of United States income
tax treaties on tax haven use;

Fifth, describing the United States information gathering
capability, the problems caused by limitations on our information
gathering ability, and presenting options for improving
United States information gathering;

Sixth, an analysis of the administration of the tax
laws and presenting options for improving that administration.

A number of government professionals contributed substantial
time and effort to the study. These include, George Bagley,
Clyde Donald, Vince Gambino, Ross Summers, and Bill Wells of
the IRS, Jack Feldman, Kenneth Klein, Mike Patton, and
Alban Salaman of the Office of the Chief Counsel IRS, and
Ron Cimino and Richard Owens of the Tax Division of the
Department of Justice. Roy Richards served as the research
assistant. H. David Rosenbloom, Thomas Horst, and Joel Rabinovitz
of the Office of the Assistant Secretary of the Treasury
(Tax Policy) provided useful comment and criticism of the
report. One of the most important parts of the study was
the effort to quantify the use of tax havens. The effort
was directed by Berdj Kenadjian with the help and assistance
of the IRS Unreported Income Research Group and the IRS
Statistics Division. The special efforts of Marie Yauss who
typed and retyped numerous drafts of this report are gratefully
acknowledged.

The study could not have been completed without the
support of former Commissioner of Internal Revenue,
Jerome Kurtz.

The statements of positions on legal issues in this
report are the positions of the Special Counsel for International
Taxation and are not necessarily those of the IRS or any
other agency of the Federal government.

I. Overview of Findings and Options

International tax avoidance and evasion, including the
use of tax havens to avoid or evade United States taxes, have
been of long-standing concern to the Congress and tax
administrators. Numerous provisions have been added to the
tax laws to limit such use, and to limit the erosion of the
United States tax base. In 1921, the Congress focused on
foreign subsidiary corporations that were used to "milk"
United States parent corporations. In the 1930's the Congress
focused on individuals creating incorporated pocketbooks in
tax havens and transferring assets to tax havens to avoid
paying United States tax on the appreciation. In 1962 the
Congress focused on perceived abuses by multinational
corporations. In 1970 the Bank Secrecy Act imposed reporting
requirements on transactions which were believed to be
particularly susceptible to abuse. In 1976 the Congress
dealt with the use of foreign trusts.

The use of tax havens to evade United States tax has
been of special concern to the Internal Revenue Service.
Beginning in the mid-1950 's and continuing through the
1970 's the IRS conducted numerous special projects and
investigations which sought to identify taxpayers using tax
havens to avoid United States taxes. Today the IRS devotes
substantial resources to international transactions through
general civil and criminal programs and through special
programs. The use of tax havens to aid in the commission of
nontax crimes, including narcotics trafficking, has also
been of special concern to other Federal agencies.

Foreign governments have also been concerned with the use
of tax havens to avoid or evade their taxes. Some countries
have adopted legislative provisions intended to limit the
use of tax havens by their nationals. Many of these provisions
are based on United States law.

Nevertheless, legal and illegal use of tax havens
appears to be on the increase. The available data and
interviews with practitioners, IRS personnel, personnel from
other agencies and representatives of foreign governments
support the view that taxpayers ranging from large multinational
companies to small individuals to criminals are making
extensive use of tax havens.

The study was limited to transactions involving countries
having (1) low rates of tax when compared with the United
States, and (2) a high level of bank or commercial secrecy
that the country refuses to breach even under an international
agreement. Several additional characteristics of most tax
havens include: (a) relative importance of banking and
similar financial activities to its economy; (b) the availability

of modern communication facilities; (c) lack of currency
controls on foreign deposits of foreign currency; (d) self-
promotion as an offshore financial center.

Today, many tax havens thrive largely because of the
presence of foreign banks. The existence of this financial
business brings an economic advantage to the tax haven in
terms of jobs and revenue. The resulting highly developed
and sophisticated banking and communications infrastructure
in the tax havens also makes it possible to move illegally
earned income swiftly and efficiently.

The decision of a country not to tax transactions or to
attempt to attract offshore financial business is a legitimate
policy decision. When local laws and practices deny information
to countries whose tax base is being eroded or whose laws
have been violated, a situation exists that attracts criminals
and is abusive to other countries. Most tax havens have
strict secrecy provisions and will not cooperate with other
countries seeking to enforce their laws.

The data support the perception that activity through
tax haven entities has increased, and that tax haven entities
are increasingly diverting capital away from entities formed
in economically advanced countries that have highly developed
systems of taxation.

In 1968, according to IRS data, the total assets of
foreign corporations controlled by United Stated corporations
and formed in tax havens were $11.7 billion, representing
12.1 percent of the worldwide assets of United States controlled
foreign corporations. By 1976 these amounts had risen to
$55.4 billion and 17.6 percent.

Commerce Department data, while based on a different
universe, confirm these trends. Those data show a steady
growth in direct investment levels in Uhited States-controlled
tax haven businesses from $4.7 billion in 1968 to $23 billion
in 1978, a five-fold increase. For the same period, direct
investment levels in nontax haven business grew from $57.2
billion to $145.1 billion, an increase of two-and-a-half
times.

Over the same period. Commerce Department data show
earnings of tax haven entities increasing from $0.5 billion
to $4.4 billion -- a nine-fold increase — while earnings of
nontax haven entities were increasing from $6.0 billion to
$21.3 billion, or by three and a half times. Ownership by
Uhited States persons of tax haven subsidiaries has increased
more than ownership of nontax haven subsidiaries.

The data tend to confirm that some industries use tax
haven entities more than other industries. For example, in
1976 United States-controlled tax haven corporations engaged
in the transportation business had assets of $9.0 billion,
which represented 74.2 percent of the assets of united
States controlled foreign corporations in the transportation
business. The comparable figures for contract construction
were $2.2 billion and 41.8 percent. Assets of United States-
controlled tax haven companies engaged in finance, insurance,
and real estate, including banking, were $20.9 billion,
which represented 28.0 percent of the assets of Uhited
States controlled foreign corporations in that business. In
1976, $2.4 billion or 23 percent of the assets of United
States-controlled foreign corporations engaged in providing
services were held by tax haven corporations.

Banking activity in tax havens has also grown. Total
deposits in banks in the tax havens surveyed were $385
billion in 1978; deposits by nonbanks were $89 billion of
this amount. Comparable figures for year-end 1968 were $11
billion and $5 billion, respectively.

The extent to which tax havens are being used by narcotics
traffickers and other tax evaders, including those earning
legal income, could not be quantified reliably. Data concerning
illegal use of tax havens are often soft or unavailable.
The report does, however, refer to a methodology that might
be a first step in making an estimate. Present currency
flow projects may also help. The perception is that such
use is large and is growing.

There is a wide range of use of tax havens by United
States persons. While many attribute evil motives to any
such use, this is not the case. Some use is for criminal
purposes, but much is perfectly legal. In some cases the
tax consequences of the tax haven transactions reflect clear
congressional decisions as to the scope of United States
taxing jurisdiction.

From a tax planning point of view, tax havens, in and
of themselves, do not provide a United States tax advantage;
the United States tax advantage is provided only in combination
with both the Uhited States system of deferral of taxation
of earnings of foreign corporations and the United States
system of consolidated worldwide foreign tax credits.

Often whether a transaction is tax avoidance or tax
evasion is difficult to determine, in part because the terms
are not well defined, and in part because the law governing
the transactions is imprecise and the information incomplete.
There also are many grey areas. Tax havens transactions can
be loosely categorized as follows:

(1) Transactions that are not tax motivated and may
have no United States income tax impact. Such use includes
branch banking that may avoid United States reserve requirements
but has little impact on United States income tax liability.

A tax haven subsidiary may be used to avoid currency and
other controls that may be imposed by countries in which the
company is carrying on business. It may also be used to
minimize the risk of expropriation of business assets. A
foreign person may use a tax haven bank or nominee account
to shield assets from political oppressors.

(2) Transactions that are tax motivated, but consistent
with the letter and the spirit of the law. Examples are
shipping, banking through subsidiaries, sales by tax haven
subsidiaries not involving related parties as well as taking
advantage of certain de minimis exceptions to anti-tax haven
legislation. While some of these uses create anomalous
situations, they are legal. For example, a United States
taxpayer has sheltered over $100 million in passive income

in a foreign company the income of which is not taxable
under the anti-avoidance provisions of the Code.

One of the most common tax motivated but legal uses of
a tax haven subsidiary is to shift United States source
income to foreign source income to increase the amount of
foreign taxes paid by a inited States taxpayer that can be
credited against, and thus reduce. United States taxes
otherwise payable by the taxpayer.

(3) Aggressive tax planning that takes advantage of an
unintended legal or administrative loophole. Examples are
the use of captive insurance companies, the use of investment
companies, some forms of service and construction businesses
being conducted through tax haven entities, as well as a
wide range of aggressive transfer pricing situations.

(4) Tax evasion — an action by which the taxpayer tries
to escape legal obligations through fraudulent means.
Fraudulent use includes marketing so-called "double trust"
schemes involving attempts by United States persons to
transfer United States assets to tax haven trusts. It also
includes marketing tax shelters, including certain questionable
commodity transactions, to United States persons through a

tax haven in order to hide the fact that the transactions
that are allegedly creating losses do not take place. One
tax straddle shelter may have involved as many as 1500
investors and deductions of as much as $150 million.

Fraudulent use has also included forming sales companies
that are structured to appear to deal only with unrelated
parties but that in fact are dealing with related parties,
forming corporations to appear to be banks, hiding the fact
of ownership of tax haven corporations, the use of a Cayman
Islands corporation by a United States person to hide
corporate receipts and corporate slush funds.

Tax havens may be used to commit crimes that violate
tax as well as other laws. The most serious fraudulent use
of this kind is by narcotics traffickers to accumulate or
launder large suras. Often phony shelter schemes violate
securities as well as tax laws. Shell banks established in
St. Vincent have been used to defraud Uhited States banks
and other businesses.

The provisions of the tax law that apply to international
transactions in general and to tax haven transactions in
particular are among the most complex in the Internal Revenue
Code. The two most important provisions affecting tax haven
transactions are subpart F, which taxes Uhited States shareholders
of a United States controlled foreign corporation on certain
categories of income, and section 482, which authorizes the
Commissioner to reallocate income among related entities to
properly reflect their income. Both of these provisions are
primarily transactional in nature, that is, each separate
transaction must be analyzed to determine its tax effect.
Also, the foreign personal holding company provisions and
the foreign trust provisions may apply.

The proper administration of subpart F and §482 often
requires IRS access to detailed books and records which are
not always available. The complexity coupled with information
gathering problems makes the law in this area extremely
difficult to administer.

Income tax treaties with tax havens are often used by
residents of nontreaty countries to achieve a reduction in
United States tax. The United States has a large and
growing network of income tax treaties mostly with other
high tax countries, but about 16 treaties are with tax
havens. Many of the tax haven treaties are the result of
the extension of the old United States-Lfriited Kingdom treaty
to former united Kingdom colonies. The treaty with the
Netherlands Antilles is in force as a result of the extension
of the united States-Netherlands income tax treaty. United
States treaties with Luxembourg, the Netherlands and Switzerland
were independently negoiated.

There is significant use of tax haven treaties for
investment in the Uhited States. In 1978, 43 percent of the
gross income paid to all nonresidents of the United States
was paid to claimed residents of tax havens. Forty-six

percent of the gross income paid to residents of all treaty
countries was paid to claimed residents of tax haven treaty
countries. Nearly 80 percent of all United States gross
income paid to residents of tax havens and reported to the
IRS was paid to corporations. All of this indicates significant
third-country use of tax haven treaties.

Third-country residents use tax haven treaties primarily
to minimize tax on income from United States investments by
a combination of reduced rates of tax on income paid from
the united States, the low rate of tax in the tax haven and
the low rate of tax on distributions to the investor from
the tax haven. The use of tax haven treaties includes
forming conduits in the tax haven to lend into the United
States, the use of holding companies engaging in back-to-
back licensing and lending transactions, real estate investment
and finance companies established by United States corporations
to borrow abroad free of the United States withholding tax.
There is some evidence of use of tax haven treaties to evade
united States tax.

In order to administer the tax laws and to prosecute
those who evade their tax obligations, the IRS and Federal
prosecutors must have access to relevant information. The
ability of the IRS to gather information is severely limited
where international transactions in general and tax haven
transactions in particular are involved. With respect to
legitimate business transactions, information-gathering
problems include the existence of multiple overlapping
forms, the sometimes inaccessabil ity of adequate books and
records of overseas entities, the uncertainty of the extent
of the United States Government's powers to compel production
of books and records maintained in tax havens, the ability
of taxpayers to use the court system to delay the production
of records and some intentional procrastination and delaying
tactics by some taxpayers.

Reports of currency transactions with domestic financial
institutions have been helpful in developing some criminal
cases, but more work is needed to improve the quality of the
information and the dissemination of the information.
Reports of transportation of currency into and out of the
united States and reports of interests in foreign bank
accounts have not been particularly useful to date.

Substantive laws are not the direct impetus to illegal
activity, although complicated laws are more susceptible to
abuse. The problem is getting information to tie the
united States taxpayer to funds accumulated in or routed
through a tax haven so that a prosecution for tax evasion is

possible. lack of meaningful exchange of information is the
real problem and that lack encourages abuse. The IRS does
not have available the process of the courts to command the
production of records that are in the hands of third parties
in the tax havens. Even if information is obtained, it is
rarely in a form admissible in United States courts.

Exchange of information provisions in the existing tax
treaties with tax havens are simply inadequate because they
do not override local bank or commercial secrecy laws. In
any event, the United States does not have treaties with
most tax havens. The only mutual assistance treaty in force
to which the United States is a party is with Switzerland,
and it has not been useful for dealing with tax crimes.

There also are some administrative problems with the
international enforcement of the tax laws, such as achieving
effective coordination among international enforcement
functions. Further, the volume of transactions with which
the IRS must deal continues to grow, but the resources
devoted to auditing international transactions have not kept
pace with the growth in international trade, and many smaller
cases, which can be the most abusive, do not receive expert
attention. The international experts are not trained in the
kinds of abusive transactions used by individuals such as
partnerships and trusts. It is difficult for criminal and
civil agents to get competent, expeditious, technical help
in the field without going through a formal referral process.

The Chief Counsel's Office also has the problem of
diffused technical expertise in the international area.
Additionally it has no easily accessable central focus of
international information gathering expertise.

It can be argued that the basic reason why there continues
to be so much tax haven activity is the lack of effective
administration by all nations, coupled with taxpayer awareness
of that lack. The central issue then becomes whether the
present legal structure is administerable or whether it
should be changed regardless of other policy concerns
because it is not administerable.

There exists the potential for a serious abuse of the
LMited States tax system through tax havens. What is needed
is a coordinated attack on the use of tax havens, including
better coordination and funding of administrative efforts to
deal with tax haven problems, and perhaps substantive
changes in United States law and treaty policy. In order to
deal with these problems, consideration of the options set
forth is recommended. While some options can be accomplished

10

administratively, others would require legislation or changes
in existing income tax treaties. We recognize the existence
of policy considerations in addition to tax considerations.
The following options are presented purely from a tax
administration point of view. Some of them would apply to
international issues in general, because it does not make
sense to limit them to tax havens.

The adoption of many of the options set forth in the
report will require that more resources be devoted to international
enforcement efforts. Today the IRS does not have the additional
resources. If decisions are made to adopt options which
require additional resources, the Congress will have to make
the resources available.

The United States alone cannot deal with tax havens.
The policy must be an international one by the countries
that are not tax havens to isolate the abusive tax havens.
The United States should take the lead in encouraging tax
havens to provide information to enable other countries to
enforce their laws. For example, the United States could
terminate tax treaties with abusive tax havens, increase the
withholding tax on United States source income paid to tax
havens and take other steps to discourage United States
business from using tax havens. However, such steps taken
unilaterally would place United States business at a competitive
disadvantage as against businesses based in other OECD
countries. Accordingly, a multilateral approach to deal
with tax havens is needed.

The more important options, summarized below, as well
as others, are presented in more detail in the following
chapters:

.Chapter VII - options for administrative and legislative
changes to deal with technical problems;

.Chapter VIII - options for changes for tax haven
treaties ;

.Chapter IX - options for information gathering;

.Chapter X - options for administration of the tax
system.

Options That Can Be Adopted Administratively . The
following options could be accomplished administratively:

1. To make clear the obligation of taxpayers to produce
the books and records of foreign subsidiaries, publish
regulations requiring that books and records of foreign

11

corporations controlled by United States persons be maintained
in the United States regardless of foreign laws, unless
those books and records are made readily available to examining
agents on demand.

2. To encourage agents to insist that taxpayers meet their
burden of substantiating deductions, valuations, or pricing,
give clear directions to the field as to actions to be taken

by agents to deny deductions or reallocate income where a
taxpayer has not met the burden of proving the tax consequences
of a transaction.

3. To ease the administrative burdens of complicated

and lengthy audits, study the §482 regulations to determine ,i

whether clearer more administerable rules are possible. i

!|

4. To address the problem of unauthorized use of !
treaties, change the present system of withholding of tax on j
payments of fixed and determinable income to foreign persons ,
to a refund system. •

5. To simplify reporting obligations of taxpayers, and j
to make the reporting more useful to the IRS, combine into

one form the existing hodge-podge of international forms I

that a united States person investing overseas must file. I

6. To improve coordination with respect to international
issues in general, and tax haven issues specifically, the
Assistant Commissioner (Compliance) could study ways of
improving coordination among the various international
functions and could consider creating a group to coordinate
tax haven issues and collect and disseminate tax haven
information.

7. To enable the IRS to provide expert coverage to tax
haven cases outside the large case program, expand the IRS
International Examination program and give the examiners
additional training in partnerships, trusts, and tax treaties.

8. To provide better information gathering guidance to
field agents and to District Counsel trial attorneys, designate
a person in the National Office of the Chief Counsel as the
international information gathering expert.

Legislative Options:

1. To relieve some of the administrative burdens and to
give more certainty to transactions involving controlled
foreign corporations formed in tax havens, expand subpart F
to add a jurisdictional test that would tax united States
shareholders of a controlled foreign corporation formed in a
tax haven on all of its income.

12

2. To enable the IRS to deal better with tax haven
businesses that are in fact run in the United States, add a
management and control test to the present jurisdictional
tests for subjecting corporations to Lfriited States tax.

3. To simplify and rationalize the taxation of tax

haven income, eliminate some of the overlap among the provisions
which deal with tax havens by combining the foreign personal
holding company provisions with subpart F.

4. To emphasize that the burden of proving the substance
of tax haven transactions is squarely on the taxpayer,
provide for the specific disallowance of a tax haven related
deduction unless the taxpayer establishes by clear and
convincing evidence that the underlying transactions took
place, the substance of those transactions, and that the
amount of the deduction is reasonable.

5. To discourage taxpayers from taking overly aggres-
sive positions on the chance that they will not be identified,
provide for the imposition of a no-fault penalty of a fixed
percentage of a large deficiency resulting from a tax haven
transaction.

Treaty Options :

1. To deal directly with [Mited States tax treaties
with tax havens, terminate the existing income tax treaties
with the Netherlands Antilles and the United Kingdom extensions
and consider terminating income tax treaties with other tax
havens, with possible renegotiation.

2. To prevent future abuse, be selective in negotiating
income tax treaties with countries with which the United
States does not have a significant trade or investment
relationship, and do not enter into full scale income tax
treaties with known tax havens. As an alternative, selectively
enter into limited treaties with tax havens that would
include a nondiscrimination provision and a competent authority
mechanism and would contain an exchange of information
provision overriding bank secrecy laws and practices.

3. To ensure that information necessary to administer
the tax laws is available, and to insure that information
necessary to prosecute those who do not comply with those

laws is available, insist upon a strong exchange of information
provision in united States income tax treaties that would
override foreign bank secrecy laws and practices.

13

4. To deal with changes in local laws and practices of
treaty partners, conduct periodic reviews of treaties to
determine whether they are being abused and whether they are
serving the function for which they were initially negotiated.

5. To provide access to information to be used in
criminal prosecutions, vigorously pursue mutual assistance
treaties with the more important tax havens.

6. To encourage abusive tax havens to enter into
exchange of information agreements with the United States,
consideration may have to be given to adopting measures to
discouraging United States business from investing through
tax havens that do not give information, such as increasing
taxes on payments to those tax havens.

7. To limit the potential for abuse of treaties with
tax havens, and to limit the incentive for treaty partners
to adopt tax haven practices, incorporate strong provisions

to limit the use of treaties to residents of a treaty country.

14

II. Tax Havens - In General

In this chapter, an attempt is made to set out the
principal characteristics of tax havens, to explain some of
the background, and to present some of the issues raised by
tax havens from the perspective of the tax haven. The
concern of countries other than the U.S. and some of the
steps which they have taken to deal with tax havens is also
described .

A. Characteristics

The term "tax haven" has been loosely defined to include
any country having a low or zero rate of tax on all or
certain categories of income, and offering a certain level
of banking or commercial secrecy. Applied literally, however,
this definition would sweep in many industrialized countries
not generally considered tax havens, including the United
States (the U.S. does not tax interest on bank deposits of
foreigners) .

The term "tax haven" may also be defined by a "smell"
or reputation test: a country is a tax haven if it looks
like one and if it is considered to be one by those who
care. Many publications identify jurisdictions as tax
havens, and the same jurisdictions generally appear on all
of the lists.—

Most jurisdictions which are considered tax havens have
at least some of the characteristics described below. All,
however, offer low or no taxes on some category of income,
as well as a high level of confidentiality to banking
transactions .

Many countries having tax haven characteristics are
often bases for minimizing taxation on various types of
perfectly legal income and activities. These same countries
provide anonymity sought by persons evading tax laws.
Accordingly, there is a problem when looking at tax havens
of combining legitimate and illegitimate activities and
confusing the former with the latter. Care should be taken
to avoid this.

V See, for example, M. Langer, Practical International

Tax Planning , 278, 279 (2d ed . 1979); B. Spitz, Tax Haven
Encyclopaedia (1975).

15

1 . Low Tax

Many of the jurisdictions that are considered tax
havens do impose taxes. All, however, either impose no
income tax on all or certain categories of income, or impose
a tax which is low when compared to the tax imposed by the
countries whose resident taxpayers use them.

Some jurisdictions do not impose income taxes, or
impose very low rates of tax. In the Caribbean, the Bahamas,
Bermuda, the Cayman Islands, and the Turks and Caicos do not
impose any income or wealth taxes. In some cases the tax
situation may be part of a policy to attract banking, trust
or corporation business. In other cases it may exist because
the country never found the need to impose tax.

Often, low tax rates are considered an evil. However,
many tax havens are small less-developed countries whose
residents are generally poor. In many cases, the small
population of the country makes an income tax system impractical.
Instead, the country will establish a license or fee system
for generating revenue. Instead of imposing an income tax,
fees can be charged for bank licenses, commercial charters,
and the like. Administration costs of collecting those
revenues are kept to a minimum.

Often jurisdictions, while imposing significant domestic
taxes, impose low rates on certain income from foreign
sources, a tax system used by a number of developed high tax
countries (such as France) as well as by some tax havens.
Panama is an example. Accordingly, a local corporation can
be formed and managed in the tax haven with no tax being
paid to the tax haven on its income from other jur isictions.

Some tax havens impose low rates of tax on income from
specific types of business. Some jurisdictions, for example,
offer special tax regimes to holding companies, making them
especially useful as financial centers or situs for holding
companies.

Some tax havens combine their tax system with a treaty
network. This combination can make them a desirable situs
for forming a holding company to invest in a treaty partner.

2. Secrecy

By definition, all of the jurisdictions with which we
are concerned, afford some level of secrecy or confiden-
tiality to persons transacting business, particularly with
banks. This secrecy has its origin in either the common law
or in statutory law.

16

Conunon law secrecy is found in those jurisdictions
which were or still are British Colonies. It derives from
the finding of an implied contract between a banker and his
customer that the banker will treat all of his customer's
affairs as confidential. If violated, an action for damages
for breach of contract lies against the banker.

Many jurisdictions have confirmed or strengthed the
common law rules by statute, and have added criminal sanc-
tions for breaching secrecy. In many cases the law was
strengthened to maintain or improve the particular juris-
diction's competitive position. For example, in 1976 the
Cayman Islands, which had strict bank secrecy before, tightened
its laws by adding more substantial sanctions against persons
divulging most banking and commercial information.— ^,This
tightening was a reaction to United States v. Field ,— in
which the U.S. court directed a Cayman resident to give
testimony concerning bank information before a U.S. grand
jury, even though the testimony would violate the bank
secrecy laws of the Cayman Islands and would subject him to
limited criminal penalties.

Some level of secrecy is a characteristic common to
both tax havens and non-tax havens. Most countries do
impose some level of protection for banking or commercial
information. At the same time, however, many countries will
not protect information from a legitimate inquiry from a
foreign government, particularly where that inquiry is made
under a treaty. Tax havens, however, refuse to breach their
wall of secrecy, even where a serious violation of the laws
of another country may be involved. The distinction is
between unreasonably restrictive rules of bank secrecy which

2/ Langer and Walker, "The Cayman Islands - An Important

Base for Foreign Companies," U.S. Taxation of International
Operations, II 8503, Prentice Hall (1978).

3/ united States v. Field , 532 F. 2d 404 (5th Cir. 1976);
cert, denied, 429 U.S. 940 (1976).

17

may encourage the commitment of international tax and other
offenses, and those wh^ch pay due regard to the protection
of individual privacy,-'^ but which also permit legitimate
inquiry in appropriate cases.

Secrecy is most troublesome when a violation of U.S.
criminal laws is under investigation. It also presents
significant problems to IRS when it attempts to audit legal
transactions. The secrecy may be used as an excuse by a
taxpayer not to produce records, or it may present real
problems preventing IRS access to records.

3. Relative Importance of Banking

Banking tends to be more important to the economy of a
tax haven than it is to the economy of a non-tax haven.
Most tax havens follow a policy of encouraging offshore
banking business. This is done by distinguishing between
resident and nonresident banking activity. Generally,
nonresident activity will not have reserve requirements,
will be taxed differently (if at all), and will not be
subject to foreign exchange or other controls.

One test of the importance of banking to an economy is
the relationship of foreign assets of banks in a country to
that country's foreign trade. When compared to foreign
trade, foreign assets of deposit banks in tax haven jurisdictions
were substantially greater than foreign assets of deposit
banks in non-tax havens. Special statistics developed to
measure the excessive holdings of foreign assets of tax
haven banks indicate that these excess assets— are very
large, and have^been growing at a rapid rate. For all tax
havens surveyed— excess foreign assets grew from $16.7

4^/ See Recommendation 833 (1978) on Cooperation Between
Council of Europe Member States Against International
Tax Avoidance and Evasion, 1M1 4 and ll(i).

5^/ Excess assets are those above the worldwide average
of foreign assets of deposit banks to worldwide
foreign trade. The amount above what this ratio would
yield was the excess assets for that jurisdiction. For
example, 1978 total foreign assets held by deposit banks
in the Bahamas were $95.2 billion. Based on the world-
wide average of deposits to world trade, $1.8 billion
was needed to finance the foreign trade of the Bahamas.
The difference, $93.4 billion, represents excess inter-
national assets and is an indication of assets attracted
because of the tax haven status of the jurisdiction.

6^/ For this purpose, Bahamas, Bermuda, Cayman Islands, Hong
Kong, Luxembourg-Belgium (the foreign trade data for the
two countries could not be separated), Netherlands
Antilles, Panama, Singapore, and Switzerland.

18

billion in 1970 to $272.9 billion in 1978. During the same
period, excess foreign assets in tax havens, as a percentage
of foreign assets held worldwide grew from 12.5 percent to
29.1 percent. When all jurisdictions were compared, only
13 out of 126 have foreign assets which are excessive relative
to the world average in 1979. These 13 are the tax haven
jurisdictions studied and the United Kingdom and France.
The U.K. is an offshore financial center itself, and its
data include the tax havens of the Channel Islands and the
Isle of Man which could not be separated from all other U.K.
data. France has excess deposits, largely because export
financing aid is handled through private banks.

The importance of U.S. banks to the major Caribbean financial
centers is growing. For example, from 1973 to 1979, total assets
of U.S. bank branches increased nine times in the Cayman
Islands, .eight times in the Bahamas, and four times in
Panama.—

The banking industry has a significant effect on the
economy of the tax haven. Financial business yields revenues
in the form of fees and modest taxes on financial institutions.
The tax haven also benefits from employment of personnel and
rental of facilities. The Bahamas Central Bank estimated
that expenditures of banks and offshore branches in the
Bahamas in 1975 was $32,886,000, including $18,330,000 for
salaries. Licenses and other fees amounted to $1.5 million,
and the banks employed 1,890 (1,650 Bahamians) people.—
Informed sources estimate that by early 1978, the banking
sector may have employed 2,100 people (1,897 Bahamians),
paying them salaries in excess of $26 million per annum. An
additional 10,000 jobs may have been indirectly supported.

A comparable survey of the Cayman Islands indicates
that, in 1977, total operating expenditures by Cayman branch
banks were $10.2 million, of which $5.3 million were for
salaries. These branches paid $1.6 million in fees and
employed 433 people, of whom 298 were local citizens.—

2/ See Hoffman, Caribbean Basin Economic Survey ,

Federal Reserve Bank of Atlanta, May/June/July 1980,
at 1.

£/ C.Y. Frances, Central Banking in a Developing Country
with an Offshore Banking Centre , Central Bank of the
Bahamas (1978).

9/ Cayman Islands, Department of Finance and Development.

19

4. Availability of Modern Communications

Many of the countries considered tax havens have excel-
lent communictions facilities, particularly good telephone,
cable and telex service linking them to other countries.
They may also have excellent air service. For example, the
Cayman Islands has excellent telephone and telex facilities.
In fact, telephones in the Caymans can be direct dialed from
the United Kingdom and Canada. There are two daily non-stop
jet flights between Miami and the Caymans, and direct service
between Houston and Grand Cayman.

5. Lack of Currency Controls

Many tax havens have a dual currency control system,
which distinguishes between residents and non-residents, and
between local currency and foreign currency. As a general
rule, residents are subject to the currency controls; non-
residents are not. However, non-residents will normally be
subject to controls with respect to local currency. A
company, formed in the tax haven, which is beneficially
owned by non-residents and which conducts most of its business
outside the tax haven, is generally treated as non-resident
for exchange control purposes. Accordingly, a foreign
person can form a tax haven company to do business in other
jurisdictions. It will not be subject to the tax havens'
exchange countrols as long as it is dealing in currency of
other jurisdictions and is not doing business in the tax
haven.

These rules are adapted to facilitate the use of the
tax haven by a person wishing to establish a tax haven
corporation to do business in other jurisdictions.

6. Self Promotion - Tax Aggression

Most tax havens seek financial business and promote
themselves as tax havens. Considering the potential advan-
tages of attracting financial business, this is an understandable
activity from the point of view of the tax havens. Many of
these countries view financial business as a relatively
stable source of revenue and will actively seek it. Barbados,
for example, recently passed banking legislation intended to
improve its competitive position as a financial center.
Many jurisdictions conduct seminars, and their officials
collaborate in articles extolling the virtues of the particular
country as a haven. Some tax havens do not hide their
disdain for the concerns of other countries in this regard.

20

7. Special Situations - Tax Treaties

Most well known tax havens do not have an extensive
network of tax treaties. There are, however, some exceptions.
Knowledgeable persons consider the Netherlands to be a tax
haven, notwithstanding its sophisticated and well administered
tax system and high tax rates. This is because of its
network of income tax treaties, its special holding company
legislation, and administration of its tax laws to facilitate
the use of Netherlands companies by third country residents.
The Netherlands Antilles has an income tax treaty with the
U.S., and special Netherlands legislation, similar in effect
to a tax treaty, gives the Antilles a tax treaty relationship
with the Netherlands.

B. Background

Tax havens, or something like them, have been used for
centuries. While some tax havens have evolved through a
history of laissez-faire economic policies, others, partic-
ularly those specializing in attracting corporations, have ,
been created as a matter of deliberate government policy. — '

1. Historical Background

People have been looking for ways to avoid taxes for
many years. Likewise, governments have been using tax
incentives to attract or maintain business for many years.

For example, the ancient city of Athens imposed a tax
on merchants of two percent of the value of exports and imports,
Merchants would detour twenty miles to avoid these duties.
The small neighboring islands became safe havens in which to
hide merchandise to be smuggled into the country at a later
date. — In the middle ages, the City of London (as well as
other jurisdictions) exempted Hanseatic traders resident in
London from all taxes. — '

In the fifteenth century, Flanders (now Belgium) was a
thriving international commercial center. Its government
imposed few restrictions on domestic or foreign exchange and

10 / C. Smith, Tax Havens , 1-4 (1959).

11 / D. Wells, Theory and Practice of Taxation , 91
(1900), (Wells ).

12 / C. Doggart, Tax Havens and Their Uses , 1-5
(1979), (Doggart) .

21

freed much trade from duties. English merchants supplied
the needed raw materials, preferring to sell wool to Belgium
rather ^^^n to England where they would incur numerous
duties. — '

Holland (which some consider a tax haven today) was a
tax haven during the sixteenth, seventeenth, and eighteenth
centuries, applying a minimum of restrictions and duties.
The commerce attracted made its ports important.—'^

International tax avoidance is not new to the U.S. In
1721, the American colonies shifted their trade to Latin
America , in order to avoid paying duties imposed by Eng-
land. — The tax morality which developed from this avoid-
ance of English duties has been described as follows: "The
fact that the colonists were constantly evading the naviga-
tion acts, and made no pretense of paying the duties imposed
by England must have had a demoralizing effect, and taught
them , to evade duties imposed by their own lawmakers . . .

2, Modern Background

The prototype of the modern tax haven is Switzerland,
which developed as a "haven" for capital (rather than as a
"haven" from tax) for those fleeing political and social
upheavals in Russia, Germany, South America, Spain and the
Balkans. —

Today, most major havens are also offshore financial
centers, that is centers for international borrowing and
lending in non-local currency. International banking dates
back to the Renaissance, and modern international banking to
the early nineteenth century. — Initially, European banks

13 A. Barton, World History for Workers , 52 (1922).

14/ Wells , at 74.

15 / Hill, Early Stages of the United States Tariff Policy ,
36.

16 / Id . at 36.

17 / Doggart , at 1.

18 / This portion of the report is based to large extent
on J. Sterling, Unpublished thesis, John Hopkins
University.

22

grew and branched out to finance the burgeoning international
trade. The Bank of Nova Scotia, Canada's second oldest and
fourth largest chartered bank, opened its first office in
the Caribbean in 1889 in Jamaica. — '

Offshore financial centers really began to grow in the
1950's. After World War II, eurocurrency lending (lending
by a bank in a currency other than that of its country of
residence) grew rapidly. In the 1950 's a European market
for dollars outside of the U.S. developed. The uncertain
world situation, the increased awareness of corporate treasurers
of the advantages of depositing dollars abroad (higher
interest), and other factors led to an escalating growth in
this market. The imposition by the U.S. of the Interest
Equalization Tax ( lET) in 1963, the increased sophistication
of American banks, and the increasing credit controls imposed
by the U.S. helped the market to grow. The web of rules in
the mid 1960's, including the voluntary Foreign Credit
Restraint Program (VFCR) in 1965 and the Offices of Foreign
Direct Investment (OFDI) regulations, which required U.S.
persons investing abroad to borrow abroad, really launched
the offshore market. It was this latter provision which
most increased the offshore market. In 1969, the Federal
Reserve Board agreed to permit the establishment of shell
branches abroad so that smaller banks could compete in the
international financial market. Most of these shell branches
are in the Bahamas or the Cayman Islands.

3. Present Situation

Today, tax havens thrive in large part because of the
presence of foreign banks. As described above, the existence
of this financial business clearly brings an economic advantage
to the haven in terms of jobs and revenue. It may stimulate
tourism and attract wealthy retirees who spend their money
in the haven. The financial activities create an infra-
structure which can be used by criminals to hide money as
well as by legitimate businesses.

C. Reasons for Use of Tax Havens

Before describing the U.S. tax system as it applies to
tax haven transactions, it is useful to attempt to understand
why business is done there. Obviously, the low rates of tax
afforded by tax havens are an inducement. There are, how-
ever, uses which do not appear to have a significant
tax impact. These include:

19 / See The Bank of Nova Scotia Annual Report, 1978.

23

(1) confidentiality;

(2) freedom from currency controls;

(3) freedom from banking controls, particularly the
reserve requirements.

(4) receipt of higher interest rates on bank deposits
and to borrow at lower interest rates.

Often the physical location is not important. Obviously,
if one is running a hotel in the Bahamas one must be in the
Bahamas, but if one is participating in the Eurodollar
market one can do it from New York as well as from Nassau.

Today, most large banks have branch offices in the
Bahamas and the Cayman Islands. They are there primarily to
participate in the Eurodollar market free of U.S. control.
Often they take dollar deposits from foreign persons and
lend them to their foreign customers, who are often subsidiaries
of U.S. companies. These transactions could be done in the
U.S., but the deposits would be subject to reserve requirements
imposed by the Federal Reserve. Under these requirements, a
portion of any deposit must be held and cannot be lent out,
thus that reserved portion cannot produce income. Accordingly,
it is more profitable to operate overseas where as much of a
deposit as a bank wishes can be lent or invested.

A stable tax haven might also be preferable as a cor-
porate situs if one is conducting an active business in a
potentially unstable country. For example, a U.S. company
wishing to engage in the heavy construction industry in a
less developed unstable country, could do so by forming a
Bahamian subsidiary, which would then make the investment
in that unstable country and conduct the operation. Any
profits and assets which need not be maintained physically
in that country could be moved out and kept in a branch bank
in the Bahamas. In this way, the risk of an expropriation
is minimized. By forming a corporation in a tax haven,
there is no additional level of tax on the profits, and
there is little danger of income being blocked by the
imposition of currency controls.

Another reason to use a tax haven is anonymity. Bank
secrecy prevents the country in which a tax has been evaded
or another crime has been committed from obtaining the
documentary evidence needed to prosecute the offender. The
huge volume of financial transactions conducted in a tax

24

haven also gives a certain level of confidentiality to
transactions. Accordingly, a criminal may use a high volume
financial center tax haven such as the Cayman Islands because
the Cayman Islands will not divulge bank information, and
because his transactions are indistinguishable from and can
be lost among other legitimate transactions.

D. Foreign Measures Against Tax Havens

The use of tax havens to avoid or evade taxation is a
problem which affects almost all developed and developing
countries. Problems of international evasion are not new.
In fact, the first tax treaty signed August 12, 1843, was an
agreement concerninq-.administrative assistance between
Belgium and France. — ' Attempts to deal with tax havens
have been undertaken unilaterally, as well as on a bilateral
and multilateral basis. The concern about tax havens is
illustrated by a German-French Memorandum-,on Tax Evasion
and Avoidance on the International Level. — '

1. Unilateral Approaches

The developed countries have taken steps to deal with
tax havens. Most have been through tax legislation; some
have involved currency controls.

a. Tax legislation

Many of the legislative initiatives of other countries
are based on U.S. legislation. Provisions similar to subpart
F (which taxes U.S. shareholders on certain income of con-
trolled foreign corporations) exist in the tax laws of
France, Germany, Canada and Japan.

(i) Provisions similar to subpart F . Under the German
provision, the passive income of a controlled foreign corporation
is deemed to accrue to German shareholders if the income is
subject to a low tax rate, which is defined as a total tax

20 / Manual for the Negotiation of Bilateral Tax Treaties
Between Developed and Developing Countries, United
Nations Publications, ST/ESA/94(1979) , 29. For a
historical overview of bilateral and multilateral
efforts to deal with international evasion and avoidance
see id, at 29-32.

21 / 14 European Taxation , No. 4, 136 (April 1974).

The concern with tax havens was made especially clear.

25

burden of less than 30 percent. The control requirement is
satisfied if the German shareholders have more than one-half
of the control of the foreign corporation. The existence of
a treaty containing the "affiliation privilege," (which
treats the income from a foreign subsidiary as tax-exempt in
the hands of the German parent company if such company holds
a participation of at least 25 percent in the foreign subsidiary)
prevents the application of this provision.

The Canadian provision requires that the Canadian
shareholder of a controlled foreign affiliate include in
income "foreign accrual property income" in proportion to
participation. "Foreign accrual property income" includes
the affiliate's income from property and businesses other
than active businesses, as well as capital gain which is
unrelated to active business activity. The percentage
ownership required for control, in order to be treated as a
shareholder, is similar to that under U.S. law. Like the
U.S. and unlike the other provisions modeled after subpart
F, there is no requirement that the foreign affiliate be
located in a low tax country, or that the income of the
foreign affiliate be subject to a low tax.

The Japanese anti-haven law basically provides that
Japanese income tax shall be imposed currently upon the pro
rata share of the undistributed income of so-called "specified
foreign subsidiaries" attributable to Japanese resident or
corporate shareholders owning, directly or indirectly, 10
percent of the total shares of the foreign subsidiary. Under
the statute, a "specified foreign subsidiary" is defined
as a foreign corporation or other legal entity more than 50
percent of the issued shares of which are owned, directly or
indirectly, by Japanese residents or by corporations which
have a Japanese resident shareholder who owns or belongs to
a family shareholding group owning, directly or indirectly,
10 percent or more of the total shares issued by the foreign
subsidiary, and which is incorporated in a low tax country.
Determination of the latter is to be made by the Minister of
Finance on a case-by-case basis.

An exemption from the Japanese statute is provided if
the foreign subsidiary: is not a mere holding company; has
a physical facility in its country of residence necessary
for its business activities; has local management and control;
engages in its business activity, principally with unrelated
parties or in its country of residence, depending upon the
type of activity; has not received greater than five percent
of its gross revenues in the form of dividends from other
"specified foreign subsidiaries." The Japanese provision,
unlike the U.S. sul- ■>art F provision, does not define particular

26

types of activities as "tainted," but instead treats certain
companies, namely those incorporated in low tax countries,
as "tainted." However, the activities of the "specified
foreign subsidiary" are crucial to the determination as to
whether an exemption is to be applied.

The French provision provides that where an enterprise
liable for corporate tax owns, directly or indirectly, at
least 25 percent of the shares of a corporation based in a
country with a privileged tax regime, the French enterprise
will be taxed on the profits (whether or not distributed) of
the foreign company in proportion to its rights in the
foreign company. The standard used in determining whether
a country has a privileged tax regime is whether that
country's tax on income and profits is notably less than
the French tax. The provision will not apply if the enter-
prise satisfies the tax authorities that the foreign country
is actually engaged in industrial or commercial activities
predominantly with unrelated parties.

(ii) Transfer pricing . Most developed countries have
adopted transfer pricing rules giving their tax administrators
the authority to reallocate income or scrutinize transactions
between related parties and disallow costs which are determined
not to be arm's length. These provisions apply generally,
and are not focused particularly on tax haven transactions.

(iii) Transfers of property abroad . The United Kingdom
taxes a United Kingdom resident who has the power to enjoy
the income of a foreign person (including a foreign corporation
or trust) . The income is treated as income of the resident.
For it to be taxed, it must have arisen from assets transferred
out of the United Kingdom. The provision also treats as
income of a U.K. resident any capital sum (including amounts
categorized as a loan) that a U.K. resident is entitled to
receive with respect to the property transferred, to the
extent of income generated by the transferred property.
Therefore, if property is transferred abroad by a U.K.
resident to a foreign trust and the U.K. resident receives
money in the form of a loan from the foreign trust, the
amount received by the U.K. resident will be taxed to him to
the extent of any income of the trust. This provision
should be compared to § 679 of the Internal Revenue Code,
which treats a U.S. person who transfers property to a
foreign trust as the owner of the portion of the trust
attributable to such property, if for such year there is a
U.S. beneficiary of any portion of the trust.

27

The Netherlands has neither a specific provision aimed
at tax haven abuse, nor anything comparable to subpart F.
However, the transfer of property by Dutch citizens to a
foreign corporation which accumulates portfolio income is
treated as a sham transaction by the Dutch authorities. The
effect is that the foreign corporation would be treated as a
Dutch corporation or merely as a collection of Dutch individuals.

(iv) Provisions relating to deductions . Specific tax
provisions denying deductions with respect to activities
carried on in low tax countries exist under French and
Belgian law. The French tax code provides that interest,
royalties, or consideration for services paid by a person
domiciled or established in a foreign country which has a
privileged tax regime are deductible for tax purposes, only
if taxpayers prove that the expenses incurred correspond to
actual operations, and are not abnormal or exaggerated. The
definition of privileged tax regime, for purposes of this
provision, is a country in which the tax on profits or
income is noticeably less than taxes in France. Belgian law
contains an almost identical provision. Under both provisions,
the burden of proof as to the deductibility of the payments
made to the foreign entity shifts to the taxpayer. This is
contrary to many other French tax statutes.

The purpose of the French and Belgian provisions,
limiting or denying payments with respect to low tax countries
is to prevent the taxpayer from deducting payments made to
persons in countries with a privileged tax regime for facilities
or overvalued services rendered, since the taxpayer must
prove that such operation is a normal one. The French tax
authorities have found the provision quite effective.
However, it deals with merely one part of the tax haven
problem. In the normal situation, the aim is to avoid tax
on the income generated by the transferred property, rather
than to obtain a deduction for facilities provided or services
rendered by the foreign entity.

(v) Expatriation . Under German law, a provision
similar to §877 of the Internal Revenue Code applies to
German citizens or former German citizens who transfer their
residence from Germany to a low tax country and who, for
five out of the last 10 years, were German citizens or
subject to German tax as residents. If such individual

28

retains a significant economic interest in the Federal
Republic of Germany or West Berlin after transferring residence
abroad, and if the transfer is to a low tax country (a
country imposing less than 2/3 of the tax imposed by Germany),
then such individual is subject to extended tax liability as
a nonresident (which involves taxation of German source
income but without certain exemptions available to a nonresident
who did not emigrate).

The United Kingdom, under the Capital Transfer Tax Act,
imposes a tax on the transfer of property situated in the
united Kingdom. The provision applies to a domiciliary,
even if he is no longer resident in the United Kingdom. The
provision was enacted to prevent a domiciliary from trans-
ferring domicile and thereby avoiding all tax on non-U. K.
assets. If, however, the individual is not living in the
U.K., there is a practical problem of obtaining information
to enforce the provision, and of collecting the tax unless
assets are still in the U.K.

Under Canadian rules, an individual who expatriates
from Canada is subject to a tax on the appreciation of his
property on the date he expatriates. The tax is imposed on
an amount equal to the value of the property less its basis.

(vi) Special provisions . France has a specific provision
aimed at preventing artists incorporating themselves in low
tax countries and performing services in France. Under the
provision, if proceeds are received by a corporation ("artist
corporation") or other legal entity which has its seat of
management outside of France in consideration for services
rendered by persons domiciled in France, the proceeds are
taxed to the persons domiciled in France if: (1) such
persons participate, directly or indirectly, in the management,
control, or capital of the foreign legal entity; (2) if the
persons domiciled in France do not prove that the foreign
legal entities are engaged in an industrial or commercial
activity other than the rendering of services; or (3) in any
case in which the foreign legal entities have their seats of
management in a country which is not linked to France by an
income tax treaty or has a privileged tax regime. There-
fore, if a corporation has its seat of management in a tax
haven country and receives payments for services rendered in
France by a domiciliary of France, the income received from
the rendering of the services is taxed to the individual
domiciled in France.

29

b. Non-Tax Measures

Control of tax haven abuse has not been limited to tax
legislation. Australia dealt with tax haven activities
through foreign exchange controls. Under Australian law, a
transfer of funds overseas requires bank clearance. Under
the Banking Act, the reserve bank is required to refer to
the Australian Commissioner of Taxation any applications
made to the bank for authority to deal in any jurisdiction
listed as a tax haven. The Taxation Department has the
authority to issue a certificate, and may refuse to issue
the certificate if the taxpayer does not satisfy the
Commissioner that the actions proposed in connection with
the application will not involve the avoidance or evasion
of Australian tax. The foreign exchange controls through
the banking system and the requirement of a tax certificate
for transfers to tax haven countries are the principal
methods used by Australia in controlling tax haven abuses.

There is no provision in Australian law comparable to
subpart F; foreign trusts are not regulated, since transfers
are regulated; and there are no provisions restricting
deductions with respect to activities carried on in tax
haven countries. The Australian Government believes that
such provisions are unnecessary, because the foreign exchange
controls and the requirement that a tax certificate be
obtained insure that only bona fide activities in tax haven
countries would be permitted in the first place. However,
notwithstanding the controls, circumvention is possible if
a transfer were made to a non-tax haven country followed
by a transfer to a tax haven country.

France also has exchange controls which regulate the
transfer of property outside of France, but the controls are
general in nature and are not specifically directed at tax
haven abuses.

c . Effectiveness

The effectiveness of legislation against tax haven
abuse varies from country to country. Australian tax authorities
believe that foreign exchange controls and the elimination
of certain Australian territories as tax havens has been
very effective in combating tax haven abuse. However, it
was not clear that this has completely solved the problem.
For example, money could still be invested in a non-tax
haven country and then transferred to a tax haven.

30

The German experience with tax haven legislation adopted
in 1972 has been positive. Prior to its enactment, the German
tax authorities had to rely on general principles of tax law.
This gave rise to a great deal of litigation and mixed
success in courts. The litigation difficulties resulted in
a reluctance of German tax authorities to pursue cases of
tax haven abuse. With the enactment of the 1972 legislation,
the tax administration has actively pursued cases of tax
haven abuse. They have noted an increased willingness of
taxpayers to settle rather than litigate, and also have
noted a decline in use of holding companies in tax havens.
Despite the effectiveness of the legislation, there remains
a significant problem of illegal transfers and the use of
the secrecy laws of tax havens to conceal the transfer of
assets.

The French and Japanese provisions modeled after sub-
part F are new, and it is too early to ascertain their
effectiveness. As discussed previously, France has a
provision which shifts the burden of proof to the taxpayer
with respect to deductions taken relating to activities in
tax haven countries. France has found this provision an
effective tool to prevent French taxpayers from deducting
payments made to persons in countries with a privileged tax
regime for facilities or overvalued services.

Even though the recent tax haven legislation enacted
in Western Europe and Japan gives the tax administrations
the legal tools necessary to fight tax haven abuse, problems
remain due to the circumventing of the provisions by illegal
and fictitious transfers and the use of secrecy laws existing
in tax havens to frustrate tax authorities.

2. Multilateral Approaches

In the past decade, the growing concern with inter-
national tax evasion and avoidance in general, and tax
havens in particular, has led to various efforts.

The only multilateral convention dealing specifically
with international tax evasion and avoidance is the Con-
vention on Administrative Assistance in Tax Matters Concluded
by Denmark, Finland, Iceland, Norway and Sweden. This
convention was signed on November 9, 1972, and supplemented
in 1973 and 1976.

31

In 1975, the European Economic Community adopted a
resolution on measures to be taken to combat international
tax evasion and avoidance. The Council of the Community,
on December 19, 1977, adopted a directive concerning mutual
assistance on direct tax matters.

In April of 1978 the Parliamentary Assembly of the
Council of Europe adopted a recommendation on cooperation
between Council of Europe member states against international
tax avoidance and evasion. — ' This recommendation recognized
an increase in international tax avoidance and evasion, and
a lack of efficient cooperation between European tax adminis-
trations. The Parliamentary Assembly recommended that the
European countries conclude a European multilateral agreement
on combating international tax evasion and avoidance, including
an exchange of information. It also urged member governments
(which include Switzerland) "to abolish unduly strict rules
on bank secrecy, wherever necessary, with a view to facili-
tating investigations in cases of tax evasion or concealing
income arising from other criminal activities, while paying
due regard to the protection of individual privacy." The
Council also recommended that member countries refrain from
enacting holding company legislation and take actions to make
it more difficult for multinational companies to use tax
havens.

The Assembly of the Council of Europe held a colloquy
on international tax avoidance and evasion from March 5 to
7, 1980, in an attempt to define international tax evasion
and avoidance issues, which might be handled multilaterally ,
and to define approaches to the problems. The colloquy
focused on the relative advantages and difficulties of
bilateral as opposed to multilateral cooperation.

The OECD also has addressed the problem of tax avoidance
and evasion. The OECD Council adopted, on September 21,
1977, a recommendation calling upon member governments to
strengthen their powers to detect and prevent international
tax avoidance and evasion, and to develop exchanges of
information between tax administrators. A working party
of the OECD Committee on Fiscal Affairs is presently con-
sidering this problem.

22/ Recommendation 833 (1978)

32

III. Statistical Data on Patterns of Use of Tax Havens

The data relating to the volume of tax haven use are
summarized in this chapter. The data are not all inclusive.
For each of the categories the available data for the most
important tax havens for that category were included.

A. Levels of Use by U.S. Persons Through Tax Haven Companies

Data on direct investment in tax havens are summarized
below. The data are taken from forms filed by U.S. share-
holders of controlled foreign corporations and from surveys
conducted by the Commerce Department. There are large gaps
in data on the direct investment of U.S. persons which are
not corporations. Accordingly, levels of investment through
tax havens is probably understated.

Use of tax havens by U.S. persons is large and appar-
ently growing. The available data, and interviews with
practitioners and IRS personnel, have shown that taxpayers
ranging from large multinational companies to small individuals
are making extensive use of tax havens.

Direct investments in particular are growing much
faster than similar activity in the non-havens. Commerce
Department data reflected in Table 1 show that in 1968 U.S.
direct investment levels in tax haven corporations was $4.7
billion, which represented 7.6 percent of total U.S. direct
investment in U.S. controlled foreign enterprises. In 1978,
U.S. direct investment in tax haven enterprises was $23.0
billion, representing 13.7 percent of total U.S. direct
investment in U.S. controlled foreign enterprises. Between
1968 and 1978, the data show an increase of almost five
times in U.S. direct investment in business formed in tax
havens and about a two and a half times increase in investment
in non-tax haven businesses.

Commerce Department data in Table 1 show that the
earnings of U.S. controlled businesses formed in tax havens
increased from $0.5 billion in 1968 to $4.4 billion in 1978,
an increase of nine times. During the same period, earnings
of U.S. controlled businesses formed in non-tax havens
increased three and a half times from $6.0 billion to $21.3
billion.

These trends are more pronounced in some of the better
known tax havens. For example, direct investment levels in
foreign businesses formed in the Bahamas increased from less
than $0.4 billion in 1968 to $1.8 billion in 1976, approximately
a five fold increase. Over the same period, however, earnings
of those businesses increased seventeen times, from $44 million

33

to $746 million. In Bermuda, direct investments increased
from $0.2 billion in 1968 to $7.2 billion in 1978, a 37 fold
increase, while earnings increased from $25 million to $959
million, or 38 times. Most of the increases in Bermuda
occurred between 1972 and 1978, which partially reflect the
growth in captive insurance business.

IRS data in Table 2 are limited to figures reported on
the Form 2952 filed by corporate U.S. shareholders of con-
trolled foreign corporations, , These data show a similar
trend between 1968 and 1976.— There is also evidence that
tax haven jurisdictions are increasingly diverting U.S.
capital away from economically advanced countries that have
highly developed systems of business taxation. In 1968 U.S.
controlled foreign corporations formed in tax havens had
assets of $11.7 billion, which represented 12.1 percent of
the assets of all U.S. controlled foreign corporations. In
1976, such corporations had assets of $55.4 billion, which
represented 17.6 percent of the assets of all U.S. controlled
foreign corporations. IRS data show an almost five fold
increase in the assets of U.S. controlled corporations
formed in tax havens, and a three fold increase in the
assets of non-tax haven corporations.

IRS data in Table 2 show the industrial composition of
controlled foreign corporations formed in the tax havens.
The data indicate that the composition in tax havens differs
from the composition in non-tax havens. For example, assets
of manufacturing companies as a percent of assets of all
companies formed in the tax havens was 13.7 percent in 1976.
In non-tax havens, it was 54.8 percent. In tax havens, the
combined total of assets in finance, insurance and real
estate, wholesale trade, transportation (essentially shipping),
construction and services — typical tax haven industries — was
81.2 percent of total assets. For companies formed in non-
tax havens, for the same year, it was 37.8 percent.

1/ 1976 is the last year for which IRS data are available.

34

Another indication of relative tax haven use is the
pattern of growth in U.S. ownership of foreign corporations.
Data for the period 1970-1974, and 1974-1979 are taken from
Table 3. These data show that for the period 1970 to 1974
the number of wholly or almost wholly owned tax haven sub-
sidiaries decreased by 2.9 percent, while the comparable
number of non-tax haven subsidiaries increased by 7.6 percent.
For the period 1974 to 1979 this trend reversed. The number
of wholly or almost wholly owned tax haven subsidiaries
increased by 42.7 percent, and the number of wholly owned
non-tax haven subsidiaries increased by 26.4 percent.

The available figures for U.S. investment in other
foreign corporations have always shown a great pro-tax haven
bias. For the period 1970-1974, the number of tax haven
corporations in which U.S. persons owned an interest of 5 to
50 percent increased 164.8 percent, while the increase in
non-tax havens was 57.8 percent. From 1974 to 1979 the
increases were 36.4 percent in the havens and 17.1 percent
elsewhere. Patterns of growth in foreign corporations where
the U.S. interest is from over 50 to 94 percent, reflect a
similar pro-tax haven bias.

There are other indications of significant and increasing
usage of tax haven corporations to conduct business outside
of tax havens. In 1979 U.S. persons owned five percent or
more of the stock of 10,400 tax haven corporations and
52,000 corporations formed in non-tax havens. The relative
importance of those figures is more meaningful when looked
at in terms of ratios of corporations to population. In
1979, there were 55.1 such corporations formed in tax havens
per 100,000 population, and only 1.2 corporations per 100,000
population in non-tax havens. These represent increases
from 32.9 in tax havens in 1970 and from 0.9 in non-tax
havens.

The growth in ownership of Western Hemisphere tax
haven companies is even greater. In 1979 there were 108.1
foreign subsidiaries of U.S. persons per 100,000 population,
about 40 more than in 1970. In non-tax haven areas of the
Western Hemisphere the growth was negligible, from 2.0 per
100,000 of population in 1970 to 2.1 in 1979.

B. Levels of Use by Foreign Persons

Foreign investment in the U.S. through tax havens is
more difficult to measure. The indirect measures from IRS
data on non-resident alien gross income paid by U.S. payors,
and incomplete data from the Commerce Department on direct
investments in the U.S., indicate that the level of inward

35

investment from the tax havens is very high. In 1978, U.S.
gross dividends, interest and other income payments to
recipients in the havens increased $1.9 billion. These
sums as a percentage of total such payments to all non-
resident aliens were 42 percent. In 1978, payments to
Switzerland alone were about $1.2 billion, which was 26
percent of payments to all non-resident aliens. Payments to
the Netherlands Antilles was another $0.2 billion, which
accounts for an additional four percent of the total.
Thus, there is at least an indication of third country use
of tax havens for investment in the U.S.

A large portion of foreign capital invested in the U.S.
from the tax havens is flowing through business organi-
zations. In 1978, nearly 80 percent of all U.S. gross
income paid to the havens and reported to the IRS on Forms
1042S went to foreign corporations.

The use of income tax treaties with tax havens, and the
relevant data, are discussed in Chapter VIII.

C. Levels of Use by Banks

The presence of international banking facilities is
essential to tax haven use. Initially, in most instances,
assets which are to be invested abroad through a tax haven
would move through the international banking system. The
international deposits by non-banks held in banks resident
in tax havens is a major use of tax havens to hold assets.
Accordingly, this study attempted to measure levels of
banking activity in the tax havens.

The estimates were developed from national source data
in the tax havens, where available, as well as from Federal
Reserve data. In the few cases where complete national
source data were not available estimates were made.

Data for this discussion are taken from Table 4. These
data show that total deposits in banks resident in the tax
havens surveyed were $385 billion dollars at year end 1978.
This figure includes deposits by other banks as well as
deposits from non-banks. Deposits by non-banks were $89
billion at year end 1978. Comparable figures for year end
1968 were $11 billion and $5 billion respectively. The data
show a sustained very rapid growth throughout this period.
This growth occurs both before and after the rapid escalation
in the price of petroleum.

The growth appears to be even more rapid in the case of
deposits -in banks resident in the Western Hempishere tax
havens,- particularly in the case of deposits by non-banks.

2/ Primarily the Bahamas, the Cayman Islands, and Panama.

36

At year end 1978 total deposits in these banks (by both
banks and non-banks) were $160 billion, and total deposits
by non-banks were $32 billion. Most deposits in banks
resident in Western Hemisphere tax havens are in branches or
subsidiaries of U.S. banks. The Western Hemisphere data are
particularly relevant to the U.S. Since to a great extent,
the data reflect U.S. use of tax haven banking facilities.
This is because of the conveniences of using Western Hemisphere
tax havens, including the fact that they are in or near the
same time zones as the major money center banks in the U.S.

D. Levels of Use by Tax Evaders

In the course of this study members of the Unreported
Income Research Group of the Internal Revenue Service attempted
to estimate the levels of use of tax havens to further non-
compliance with U.S. tax laws. Because of the lack of
available information, it was not possible to develop reliable
estimates. Currency flow projects now underway hopefully
will develop data that, when combined with other information,
including data developed for this study, will throw some
light on illegal use of tax havens.

While the study did not estimate the use of tax havens
to hide evasion money, it did develop a methodology which,
given a firm commitment of resources over a few years,
might be extended to estimate noncompliance as a residual
derived from total tax haven funds. If this approach were
used, it would first be necessary to estimate total foreign
assets in tax havens, including nondeposit assets. (The
methodology developed for this study resulted in reliable
estimates mainly relating to international deposits held in
or through tax havens. ) Then, it would be necessary to
subtract: (1) funds invested in the tax havens which do not
belong to U.S. persons, and (2) funds invested in tax havens
which are legally earned and reported to tax authorities.

Another problem with estimating the use of tax havens
by tax evaders is that funds may be "laundered" by being
deposited in a tax haven bank and immediately withdrawn.
The volume of these kinds of transactions is almost impossible
to measure because neither data nor adequate methods to
estimate such flows are available.

The study team did estimate important aspects of tax
haven use, but because of significant data gaps, could not
develop a total estimate. Firm evidence was found that
total tax haven deposit assets were at least $118 billion at
the end of 1978. The findings on Swiss banking data give
some insight into the use of tax havens to achieve anonymity.
Swiss banks maintain three types of accounts: regular
deposit accounts, fiduciary accounts, and security-advisory
accounts. Fiduciary accounts consist almost entirely of

37

deposits by non-residents of Switzerland which are deposited
in banks outside of Switzerland. The deposits are generally
in the name of the Swiss bank, but for the account and the
risk of the depositor. The Swiss banks charge a fee of
between 1/8 and 1/2 percent of the amount of the deposit for
this service. Because this deposit in non-Swiss banks could
be made directly, it can be assumed that a significant portion
of deposits in these accounts belong to persons seeking
secrecy. It is reported that as of the end of 1978 deposits
in fiduciary accounts totaled $29.3 billion.

The security-advisory accounts are essentially trust
accounts which are expensive to maintain. The proceeds of

these accounts are not usually deposited in other banks, but >

are used to invest in other financial or fixed assets. J

There are^no data for these accounts, although based on i

estimates— and information provided by some knowledgeable i

sources, it may be estimated that total assets may range

between $60 and $140 billion. These accounts may hold ^

bearer shares, and are recognized as an important factor in ,

the Eurobond market. In any event, such figures could be »

used at least to estimate the levels of haven use to buy |J

anonymity. '

3/ M.S. Mendelsohn, Money on the Move , 221 (1980). ,

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39

Table 2
Assets of U.S. -Controlled Foreign Corporations in
Tax-Haven and Other Areas. 1968 and 1976

Total Assets* in

Tax Havens —

Other Areas

9/

All Areas —

(Amounts in Billion $s^

1968

Ml Industries

11.7

85.1

96.8

Contract construction

0.2

0.6

0.8

Manufacturing

1.8

46.7

48.4

Transportation

1.9

1.9

3.8

Wholesale trade

2.8

15.9

18.7

Finance, insurance and

real estate

3.7

9.7

13.4

Insurance

0.1

1.

.0

1.

.1

Holding and other in-
vestment companies-

1.3

2,

.4

3.

.7

Other
services

2.3

0.3

1:

.3

2.1

8,

il

2.3

)ther industries

1.0

8.4

9.4

1976

Wl Industries

■^5.4

259.0

314.4

Contract construction

2.2

3.1

5.3

Manufacturing

7.6

141.9

149.5

Transportation

9.0

3.1

12.2

Wholesale trade

10.4

28.9

39.3

Finance, insurance and

real estate

20.9

53.6

74.4

Insurance

2.4

3.

.8

6.

.2

Holding and other in-
vestment companies-

8.3

7.

.8

16,

.0

Other

10.2

42.

•Jl

52,

._2_

Services

2.4

7.9

10.4

Other industries

2.9

20.5

23.2

Assets in havens
as a percent of
assets in all
areas

12.1
26.5
3.7
50.6
15.1

27.8

12.8

34.

,7

26.

,7

11,

.4

10,

.8

17.6
41.8
5.1
74.2
24.6

28.0

38.5

51.6
19.5

23.2
12.5

- Tax-haven areas covered are the Bahamas, Bermuda, Costa Rica, Netherlands Antilles,
Other British West Indies (other than Cayman Islands^ Panama, Bahrain (for 1976
only), Hong Kong, Liberia, Liechtenstein, Luxembourg, Singapore, and Switzerland.

'/

- Sum of two components may not add up to the totals because of rounding.

- Excludes bank holding companies which are included in Other.

Source: U.S. Department of the Treasury, Internal Revenue Service, Statistics of Income —
1968-1972, International Income and Taxes, U.S. Corporations and Their Controlled
Foreign Corporations , Washington, D.C., U.S. Government Printing Office, 1979 and
unpublished tabulations on Controlled Foreign Corporations (from Form 2952) of U.S.
corporations with assets of $250,000,000 or more (giants) for 1968, 1972 and 1976.

^These were estimated for 1976 since the actual data tabulated from Forms 2952 covered only
the assets of CFCs controlled by the giants. To include also the assets of CFCs of smaller
U.S. corporations, the data on giants were stepped up based on observed ratios between total
CFCs and CFCs of giant U.S. corporations for 1968 and 1972. These ratios were projected
forward to 1976 by industry. (The step-up ratio for all industries for 1976 was 1.128 in
tax-haven areas and 1.118 in other areas.

40

Table 3

Patterns of Growth in U.S. -Owned Foreign Corporations
by Area and Percent of U.S. Ownership, 1970-1979

(In Percents)

1970-7A

1974-79

CFCs-"-

Other

CFCs"*-

Other

Owned

Other

than.
CFCs

Owned

Other

than
CFCs

95-100%

CFCs

95-100%

CFCs

Bahamas

-32.0

103.2

110.3

18.4

1.0

10.4

Bermuda ,
British Islands

82.7

119.2

247.2

19.3

64.9

109.6

81.3

281.8

640.0

284.8

290.5

254.1

Costa Rica

37.9

-6.7

86.7

61.3

67.9

36.9

Netherlands

Antilles

67.0

108.3

209.5

55.9

152.0

115.4

Panama

-24.1

12.0

218.7

20.0

33.9

23.8

Western Hemisphere

Tax-Haven areas

-9.1

56.0

172.2

53.2

45.2

42.1

Bahrain

—

100.0

-

100.0

—

150.0

Hong Kong

4.0

114.0

185.7

85.3

66.4

54.2

Liberia

11.8

39.0

233.0

1.6

65.6

29.7

Liechtenstein

0.8

123.5

118.8

16.9

-0.1

52.9

Luxembourg

2.4

50.0

200.0

8.2

16.7

12.1

Switzerland

1.4

49.8

110.3

20.6

19.9

13.8

Other tax-haven

areas

4.2

54.8

155.9

32.5

32.7

29.1

Total tax-haven

areas

-2.9

55.4

164.8

42.7

38.8

36.4

Non-tax-haven

areas

7.6

32.7

57.8

26.4

14.2

17.1

CFCs stands for Controlled Foreign Corporations, where more than 50 percent
of all the voting stock is owned by U.S. shareholders.

2
To be considered U.S. -owned, there must be at least five percent ownership.

3
British Islands consist of British Antilles, British Virgin Islands, Cayman

Islands, Montesserat, Anguila, Nevis, St. Christopher (also known as St. Kitts),

Antigua, Dominica, St. Lucia and St. Vincent.

Source: U.S. Treasury Department, Internal Revenue Service, unpublished tabulations
from Form 959.

41

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42

IV. United States Taxation of International Transactions
and the Anti-Avoidance Provisions - An Overview

The Congress has never sought to eliminate tax haven
operations by U.S. taxpayers. Instead, from time to time,
the Congress has identified abuses and legislated to eliminate
them. The result is a patchwork of anti-avoidance provisions,
some intended to deal particularly with tax havens, although
of general application, and some intended to deal with more
general abuse situations, but which might also be used by
the IRS to deal with tax haven transactions.

When dealing with illicit use of tax havens, the substantive
tax rules are rarely the problem (although lack of clarity
often encourages illicit use). Rather, gaps in United States
evidence-gathering ability hinder attempts to prosecute
evaders.

The discussion below seeks to place tax havens within
the context of the U.S. system of taxing international
transactions. When the system is analyzed, it becomes clear
that without appropriate anti-abuse provisions, the U.S. tax
system contains provisions which would encourage the use of
low tax jurisdictions by U.S. persons, and that where anti-
avoidance provisions are not effective, U.S. persons have
positively responded to this encouragement. It is also
clear that tax havens, in and of themselves, do not provide
a U.S. tax advantage; the U.S. tax advantage is provided
only in combination with both the U.S. system of deferral of
taxation of corporate earnings and the U.S. system of consolidated
worldwide foreign tax credits.

It cannot be emphasized too strongly that tax haven
problems cannot be completely divorced from the taxation of
international transactions in general, or from non-tax
policy concerns. Accordingly, some of the materials address
more general problems.

A. Policy Objectives

Stated United States tax policy is decidedly against
tax haven use. However, in practice that policy becomes
ambivalent. It reflects an unresolved conflict between the
following policy objectives:

(1) Maintaining the competitive position of U.S.
businesses investing abroad or exporting;

(2) Maintaining tax equity as between investment in
the U.S. and investment abroad;

(3) The need to provide fair rules for taxing foreign
investment ;

43

(4) Administrative efficiency;

(5) Foreign policy considerations;

(6) Promotion of investment in the U.S.

The result has been policy ambiguities and compromises
in legislation which have failed to resolve these conflicts,
and which have left U.S. law without a clear focus with
respect to tax havens. Concern for administrative feasibility
has been practically non-existent.

The development of U. S. taxation of foreign transactions
shows a consistent tension between these objectives. For
example, Congress introduced .the foreign tax credit as part
of the Revenue Act of 1918.— They did so not only to
provide a "just" system, but "a very wise one," without
which "we would discourage men from going out after commerce
business in different countries or residing for such purposes
in different countries if we continue to maintain this
double taxation."—

Nowhere is this tension more apparent than when it is
focused on tax havens. Nowhere is the failure to resolve
the policy issues more obvious. Congress over the years,
while maintaining deferral of tax on the earnings of foreign
corporations controlled by U.S. persons, has at the same
time passed numerous anti-avoidance provisions generally
intended to solve perceived tax haven-related problems. All
have had numerous exceptions, have been complex and difficult
to administer, and all have had gaps (many intended, some
not) .

The tension between the policies and the ultimate
attempt to deal with tax avoidance through tax havens, came
to a head in connection with the legislative deliberations
which resulted in the Revenue Act of 1962 and subpart F of
the Code.-/

1/

Revenue Act of 1918, §§222(a) and 238(a).

-/ 56 Cong. Rec . 677-78 (1918)
-/ §§ 951-964.

44

President Kennedy in his State of the Union Message had
recommended that the tax deferral accorded foreign corporate
subsidiaries of U.S. corporations be terminated in all
cases. His emphasis, however, was on haven practices. He
stated that,

"The undesirability of continuing deferral is
underscored where deferral has served as the shelter
for escape through the unjustifiable use of tax havens
such as Switzerland. Recently more and more enter-
prises organized abroad by American firms have
arranged their corporate structures aided by artificial
arrangements between parent and subsidiary regarding
intercompany pricing, the transfer of patent licensing
rights, the shifting of management fees, and similar
practices which maximize the accumulation of profits
in the tax haven--so as to exploit the multiplicity
of foreign tax systems and international agreements
in order to reduce sharply or eliminate completely
their tax liabilities both at home and abroad."—^

The President's recommendation was,

"elimination of the tax haven device anywhere in the
world, even in the underdeveloped countries, through
the elimination of tax deferral privileges for those
forms of activities such as trading, licensing, insurance,
and others, that typically seek out tax haven methods
of operation. There is no valid reason to permit
their remaining untaxed regardless of the country in
which they are located."—

The Congress, however, refused to go as far as the
President recommended. Rather, it singled out tax haven
devices, but did not end deferral for operating companies
not considered to be using tax haven devices. The reasons
for the transaction approach reflected the policy of maintaining
the competitive position of U. S. business overseas. They
stated that their bill:

4/ ...

— ' President's Recommendations on Tax Revision; Hearings

Before the House Ways and Means Committee , 87th Cong.,

1st Sess. 8 (1961).

-/ Id. at 9.

45

". . . does not eliminate tax deferral in the case of
operating businesses owned by Americans which are
located in economically developed countries of the
world. Testimony in hearings before your committee
suggested that the location of investments in these
countries is an important factor in stimulating American
exports to the same areas. Moreover, it appeared that
to impose the U. S. tax currently on the U.S. shareholders
of American-owned businesses operating abroad would
place such firms at a disadvantage with other firms ,
located within the same areas not subject to U.S. tax."— '^

In fact, subpart F as finally enacted was a limited

response to President Kennedy's initial proposal. Only the )

most obvious tax haven issues identified at the time were J

addressed. «

The evidence submitted during the 1961 and 1962 delibera- [j

tions demonstrated a significant use and rapid growth of tax ^

havens by U.S. multi-nationally based corporations.— A .

memorandum and letter submitted by the Treasury described E

the various types of operations and the recurrent severe , r

administrative problems in dealing with the operations.—''^ ^

i

Nevertheless, in reality, subpart F was not drafted in g

terms of companies formed in tax havens. Rather, it focused n

on defined activities conducted abroad which were generally
considered tax haven devices. While the Congress repeatedly
referred to the provision as an anti-tax haven provision, in (

fact, it can apply in developed countries as well as in tax k

havens. It is transactional, not jurisdictional. The j

Congress also provided significant exceptions from the

application of subpart F for certain businesses. In 1975

and again in 1976, significant changes in some of the exclusionary t
rules were made.

¥

6/
7/

8/

H. Rep. No. 1447, 87th Cong., 2nd Sess. 57-58 (1962),
1962-3 C.B. 405, 461-462 ( H. Rep. No. 1447).

President's Recommendations on Tax Revision; Hearings
Before The House Ways and Means Committee , 87th Cong.,
1st Sess. 3522 (1961). In 1978, President Carter also
recommended elimination of tax deferral in the case of
foreign corporations owned by U.S. persons. However, the
Congress did not adopt this proposal. See President' s
1978 Tax Reduction and Reform Proposals: Hearings Before
The House Committee on Ways and Means , 95th Cong. , 2d Sess,
19 (1978).

Proposed Amendments to the Revenue Act of 1954; Hearings
on H. R. 10650 Before The Senate Committee on Finance ,
87th Cong., 2d Sess. 228 (1962).

46

In addition to legislative provisions the U. S. has in
force a network of income tax treaties, including some with
tax havens. These treaties also reflect a tension between
similiar inconsistent policy objectives and, in addition, a
policy to encourage foreign investment in the U.S.

While treaties are discussed in a later chapter, it is
worth noting at this point that their existence has clearly
attracted taxpayers to tax havens. In fact, in at least one
case (the Netherlands Antilles), the treaty may have created
a tax haven.

B. Basic Pattern

The general rules applicable to international trade and
investment apply to income from tax havens as they do to
income earned in any foreign jurisdiction. While certain
provisions were added to the Code to deal with tax avoidance
related to tax havens, there is no provision which on its
face deals specifically and exclusively with tax havens per
se.

1. General Rules

The U.S. taxes U.S. citizens^ residents and corpora-
tions on their worldwide income.—'^ The U.S. taxes non-
resident alien individuals and foreign corporations on their
U.S. source income which is not effectively connected with
the conduct of a trade or business in the U.S. They are
also taxed on their income which is effectively connected
with the conduct of a trade or business in the U.S. whether
or not that income is U.S. source or foreign source.—'^

Income which is effectively connected with the conduct
of a trade or business in the U.S. is subjected to tax at
the normal graduated rates on a net basis.— ^ Deductions
are allowed in computing effectively connected taxable
income, but "only if and to the extent that they are connected
with income which is effectively connected . . . . "_/
Deductions and credits are allowed only if the taxpayer
files a true and accurate return.—^

9/

-' See § 1 and § 11.

—^ §§871, 881, and 882.

—^ §§ 871(b)(1) and 882(a)(1).

—^ §§ 873(a) and 882(c)(1).

— ' §§ 874(a) and 883(c)(2); Brittingham v. Commiss ioner,
66 T.C. 373 (1976).

47

United States source non-ef f ectively connected interest,
dividends, rents, salaries, wages, premiums, annuities, and
other fixed or determinable income received by a non-resident
alien or foreign corporation are subject, to tax at a rate of
30 percent of the gross amount received. — ' The net U.S.
source capital gains of a nonresident alien present in the
U.S. for at least 183 days during a taxable year are taxed
at the 30 percent rate. — ' The 30 percent rate on these
various income items may be lowered by treaty.

Until 1980, a non-resident alien or foreign corporation
could elect to treat all income from U.S. real property
(including gains from its disposition, rents or royalties
from natural deposits, and certain gains from the disposition

of timber) as effectively connected income, and thus have it
taxed on a net basis. — ' Once made, an election could not
be revoked without the consent of the IRS. — '

The 30 percent flat rate of tax on non-resident aliens
not engaged in trade or business in the U.S. is imposed on
payments from U.S. sources. United States source payments
are defined in § 861 to include interest paid by a U.S.
person and dividends paid by a domestic corporation, with
certain exceptions for payments from persons most of whose
income is from foreign sources. U.S. source payments also
include certain interest and dividends paid by a foreign
corporation which earned more than 50 percent of its income
from a U.S. business. — ' This gross tax on fixed or determinable
income is often reduced or eliminated in the case of payments
to residents of countries with which the U.S. has an income
tax treaty. — '

The 30 percent (or lower treaty rate) tax imposed on
U.S. source non-ef fectively connected income~paid to foreign
persons is collected by means of withholding. — The person

14/
15/

§§ 871 (a) and 881 (a).
§ 871(a)(2).

— / §§ 871(d)(1) and 882(d)(1).

17/

§§ 871(d) (2) and 882(d) (2) .

— / §§ 861(a)(1)(C) and 861(a)(2)(B)

19/

Treaties are discussed in Chapter IX.

20/

— ' §§ 1441 (individuals) and 1442 (corporations).

48

required to withhold is specifically liable for the tax but
is indemnified under the Code against any claims for the
withholding tax other than claims by the U.S. — ' Statutory
exceptions from withholding are provided, including one for
income effectively connected with the conduct of a trade or
business within the U.S. — '

Under the regulations, the obligation to withhold in
the case of dividends depends upon the recipient's address.
In the case of interest and royalties, it depends on a
certification by the taxpayer. Thus, withholding on a
dividend payment is required if the shareholder's address is
outside of the U.S., but not if the address is inside the
U.S. — ' An exemption from withholding can be claimed on the
basis of U.S. citizenship or residence. —

Certain exemptions from the gross tax are provided.
Bank account interest is defined as foreign source interest
and, therefore, is exempt. — ' Likewise, interest and dividends
paid by a U.S. corporation which earns less than 20% of its
gross income from U. S^^sources is defined as foreign source
income and is exempt. — Exemptions are also provided for
certain original issue discount and for income of a foreign
government from investments in U.S. securities. Our treaties
also provide for exemption from tax in certain cases.

Worldwide taxation can result in double taxation of
foreign source income. The U.S. seeks to mitigate this
double taxation by permitting a dollar-for-dollar credit
against U.S. tax imposed on foreign source income. The
limitation to foreign source income is computed on a world-
wide consolidated basis. Here all income taxes paid to all
foreign countries are combined to offset U.S. taxes on all
foreign income. A credit is also provided non-resident
aliens and foreign corporations, but only for certain foreign
taxes imposed on foreign effectively connected income. —

21/ § 1461.

— / § 1441(c) (1).

— / Treas. Reg. § 1 . 1441-3 (b) ( 3 ) .

— / Treas. Reg. § 1.1441-5(a) and (b).

— / § 861(a) (1) (A) and (c).

— / § 861(a)(1)(B) and (a)(2)(A),

21/ § 906.

49

2. United States Taxation of Property Held by a Foreign Trustee

For tax purposes, foreign trusts in general are treated
as non-resident alien individuals. To qualify as a foreign
trust, the entity must be both a "foreign trust," as defined
in § 7701(a)(31) and Treas. Reg. § 301 . 7701-4^ and considered
to be a non-resident or foreign situs entity. — '

Because it is taxed as a nonresident alien, a foreign
trust which has U.S. source income not effectively connected
with its conduct as a U.S. trade or business, would be taxed
at the flat 30 percent rate on certain passive income and
gains. Also, interest on amounts deposited with U.S. banks
that is received by the foreign trust is not considered U.S.
source income and, therefore, not taxed to the trust. If
such interest, however, is "effectively connected" with the
conduct of a U.S. trade or business, it may still be taxable.

29/

A foreign trust which is engaged in a U.S. trade or
business is taxable at the normal graduated rates on all
income effectively connected with the conduct of that trade
of business, whether such amounts are sourced within or
without the U.S.—' Prior to 1980 legislation, a foreign
trust, as a non-resident alien, could make the special
election under § 871(d) in the case of "real property income"
as defined in § 871(d)(1).

A foreign trust which is not a grantor trust can be
used to defer U.S. tax on income from property, even when
held for the benefit of a U.S. person. In 1962, the Congress
first dealt with tax avoidance by the use of foreign trusts.
The beneficiaries of foreign trusts created by U.S. persons
were subjected to an unlimited throw-back rule at the time
of the ultimate distribution of accumulated income.

In 1976, the Congress passed legislation intended to
eliminate the deferral privilege accorded foreign trusts
created by U.S. persons for the benefit of U.S. beneficiaries.
Ifrider that legislation, a U.S. person who directly or indirectly
transfers property to a foreign trust is treated as the

—^ See Rev. Rul. 60-181, 1960-1 C.B. 257; B.W. Jones Trust
V. Commissioner, 46 B.T. A. 531 (1942), af f 'd, 132 F.2d.

914 (4th Cir. 1943) .
— / §§ 861(a)(1)(A) and 861(c).
— / § 871(b).

50

owner for the taxable year of that portion of the trust
attributable to the property transferred, if for the year- ,
there is a U.S. beneficiary for any portion of the trust.—'
Therefore, the U.S. grantor is taxed on the income.

3. Taxation of Corporations and Their Shareholders

The U.S. taxes corporations and their shareholders
under the so-called "classical" system of corporation taxation,
a system under which a corporation and its shareholders are
separately taxed. In general, corporate earnings are taxed
to the corporation and not to its shareholders, and a share-
holder is taxed only on dividends received.

The same system governs the taxation of foreign corpora-
tions and U.S. persons who are shareholders of foreign
corporations. In general, the earnings of the foreign
corporation are not taxed until the shareholder receives a
dividend from the corporation. Also, the general jurisdictional
rules described above apply to a foreign corporation with
U.S. shareholders, even if those shareholders control the
corporation. Accordingly, a foreign corporation controlled
by U.S. persons is taxed only on its income from U.S. sources
and on its foreign effectively connected income.

A shareholder of a corporation may also be taxed when
he sells or exchanges his stock of the corporation, or when
he transfers property to it or receives property from it.
The Code, however, contains numerous provisions providing
for nonrecognition of gain in such cases.

A corporation can be easily utilized to the tax advantage
of its shareholders. In the domestic context, the advantage
can generally occur because of the differential in rates of
tax between corporations and individuals. In the foreign
context that differential may be much larger, and if a tax
haven is used, the rate of tax imposed on the corporate
earnings may be zero.

Absent the anti-avoidance provisions in the law, cor-
porations can easily be manipulated by U.S. shareholders
engaged in foreign transactions. In the simplest case, a
U.S. person could, in a transaction which qualifies for non-
recognition treatment, transfer income producing assets
(such as stock or bonds) to a foreign corporation organized

— / § 679(a)(1).

51

in a zero tax jurisdiction. The income earned by the foreign
corporation would not be taxed by the U.S. or by the zero
tax jurisdiction. The assets remain under the control of
the U.S. person, but the income would not be taxed until
repatriated. The shareholder would be taxed on the sale of
the stock, but at favorable capital gains rates. If the
shareholder holds the stock until he dies, it is subject to
U.S. estate tax but passes to his heirs free of income tax
at its value as of the date of his death. His heirs could
then liquidate the foreign corporation free of income tax
(because of the step-up in basis by reason of the shareholder's
death) and return the property to the U.S. to start again.
Or, they could maintain their ownership in the foreign
corporation and shelter the income.

Another manipulation could occur if a parent cor-
poration selling goods overseas forms a foreign corporation
in a tax haven to make those sales. The parent would then
sell the goods to the subsidiary at a small or zero profit,
and the subsidiary would sell them to the ultimate customer
at a substantial mark-up. The profit on the sale would not
be taxed by the U.S. and could accumulate free of tax in a
tax haven.

In order to curtail what it, from time to time, cate-
gorized as abuses, the Congress has periodically adjusted
the system of taxation and the non-recognition provisions of
the Code. Because of the resulting anti-abuse provisions,
the simple manipulations just described are not possible.

C. Anti-Abuse Measures

Since the adoption of the income tax in 1913, Congress
has incorporated into the tax laws numerous provisions in-
tended to correct perceived deficiencies. Some were intended
to mitigate double taxation, while others were intended to
deal with abuse. There follows a summary of the anti-abuse
measures. While most are technically applicable to foreign
corporations, those that have not been specifically tailored
to foreign corporations tend not to be useful to curb tax
haven abuse.

1. Accumulated earnings tax . The accumulated earnings
tax was the earliest anti-abuse measure. — ^ As originally
adopted, if a corporation were formed or fraudulently availed
of to accumulate income, then each shareholder's ratable

—' Revenue Act of 1913.

52

share of the corporation's income would be taxed to him.
The provision was amended in 1921 to impose a penalty tax on
a corporation when it unreasonably accumulated earnings for
purposes of avoiding income tax of the shareholders by
permitting the earnings and profits of the corporation to
accumulate instead of being distributed. The operative test
is accumulation beyond the reasonably anticipated needs of^ ,
the business. The 1921 structure continues in use today.— '^
The tax clearly applies to the U.S. source-, income of a
foreign as well as a domestic corporation. —

2. Transfer pricing . In 1921, the Congress gave the
Commissioner the authority to "consolidate accounts for
related trades or businesses" for the purpose of "making an
accurate distribution or apportionment of gains, profits,
income, deductions, or^capital between or among such related
trades or businesses." — ' The provision was replaced in
1928 by the predecessor of § 482, which provided for the
allocation of gross income or deductions between or among
related trades or businesses.

In 1968, in response to Congressional proding during
the Revenue Act of 1962, the IRS published revised detailed
regulations setting forth the standards it will apply in
shifting income among related entities to prevent tax avoidance.

Today, §482 is one of the most important anti-avoidance
provisions in the law, and is, along with subpart F, the
central focus of IRS international enforcement efforts. In
1979 the tax value of § 482 adjustments proposed by international
examiners was $500 million, which represented 36 percent of
the tax value of all adjustments proposed by the international
examiners .

3. Sections 367 and 1491 . In 1932, the Congress,
recognizirig that the various Code provisions permitting
nonrecognition treatment for gains realized in certain
exchanges and reorganizations involving foreign corporations
constituted "serious loophole [s] for the avoidance of taxes,"— '''^
enacted the predecessor to § 367. That section and its
successors have uniformly provided that a taxpayer seeking
nonrecognition treatment for gains realized on certain
foreign transfers must show to the "satisfaction" of the

33/
34/
35/
36/

§§ 531-537.

§ 532(a) .

Revenue Act of 1921, § 240(d).

H.R. Rep. No. 708, 72d Cong., 1st Sess., 20 (1932),
1939-1 C.B. (Part 2) 457, 471.

53

Commissioner, that the transaction does not have as one of

its principal purposes the avoidance of Federal income

taxes. Nonrecogni tion treatment requires a ruling issued
under that provision.

Today's version of § 367 distinguishes between trans-
fers from the United States and all other transfers. For
transfers from the United States, non-recognition treatment
is not available unless, pursuant to a request filed not
later than 183 days after the beginning of a transfer, it is
established to the satisfaction of the Commissioner that the
exchange does not have as one of its principal purposes the
avoidance of Federal income taxes. For all other transfers
(foreign to foreign and foreign to U.S.) a ruling is not
required, but the rules governing the tax consequences are
provided in regulations which can deny non-recognition to
the extent necessary to prevent tax avoidance. — '

Also, in 1932 the Congress dealt with a second aspect
of the transfer problem and enacted the predecessor to §
1491. That section imposed an excise tax upon the transfer
of stock or securities by a U.S. person to a foreign corporation
as paid-in surplus or as a contribution to capital, or to a
foreign estate, trust, or partnership. The tax was measured
by the difference between the fair market value_Qf the
property at the time of transfer and its basis. — ' The
difference is reduced by the amount of any gain recognized
by the transferor on the transfer. Section 1491 was amended
in 1976 to apply to transfers of any property and to increase
the excise tax to 35 percent from 27 1/2 percent. The
excise tax does not apply to a transfer described in § 367
or a transfer for which an election has been made under §
1057. — ' In lieu of the payment under § 1491, the taxpayer
may elect under §1057 to treat a transfer described in §
1491 as a taxable sale or exchange, and to recognize gain
equal to the excess of the .fair market value of the property
over its adjusted basis. — '

37/

=-^' See Revenue Act of 1932, § 112(k); Revenue Act of 1934,

§ 112(i); Revenue Act of 1936, § 112(i); Revenue Act

of 1938, § 112(i); 1939 I.R.C. § 112(i).

—^ H.R. Rep. No. 708, 72d Cong., 1st Sess. , (1932), 1939-1 C.B.
(Part 2) 457, 494.

— / § 1492.

i°/ § 1057.

54

4. Personal holding companies . The undistributed
personal holding company income of a personal holding company
is subject to a penalty tax of 70 percent. This provision,
added to the law in 1934 and extensively revised in 1937 and
1964, was intended to thwart the creation of so-called
incorporated pocketbooks and the transfer of services to
corporations organized by the provider of those services.

The Congress, in adopting this provision, acknowledged that
the accumulated earnings tax was not working to prevent some
significant abuses in the area.

A corporation is a personal holding company if at least
60 percent of its adjusted ordinary gross income is personal
holding company income (passive investment income and certain
personal services income), and more than 50 percent in value
of its stock is owned by five or fewer individuals. The tax
is imposed on the corporation (not the shareholders), and
provision is made for relief from the tax to the extent a
"deficiency dividend" is paid.

A foreign corporation can be a personal holding com-
pany. However, if all of its outstanding stock during the
last half of the year is owned by nonresident aliens, then
it is not a personal holding company.

5. Foreign personal holding companies . In 1937, the
Congress, in response to a request of President Roosevelt
and the Report of the Joint Committee on Tax Evasion and
Avoidance of the Congress of the United States — ' , again
acted against incorporated pocketbooks. This time, it
focused on those incorporated abroad by U.S. persons. The
result was the foreign personal holding company provisions.
It is of interest that Congress focused on corporations
domiciled in countries such as the Bahamas and Panama, which
had little or no corporate income tax (at least on foreign
source income) and which are today considered to be tax
havens .

The U.S. shareholders of a foreign personal holding
company are taxed on their proportionate share of the cor-
poration's undistributed foreign personal holding company
income. A foreign corporation is a foreign personal holding
company if at least 60 percent of the corporation's gross
income for the year is foreign personal holding company

— / H.R. Doc. No. 337, 75th Cong., 1st Bess. (1937).

55

income, and if more than 50 percent in value of the corporation's
outstanding stock is owned (directly or indirectly) by not
more than five individuals who are citizens or residents of
the U.S.

Foreign personal holding company income includes passive
income such as dividends, interest, royalties, and annuities,
gains from sale of stocks, securities, and future transactions
in certain commodities, income from an estate or trust or
the sale of an interest therein, income from certain personal
service contracts, compensation for the use of corporate
property by 25 percent shareholders, and rents, unless they
constitute 50 percent or more of the gross income of the
corporation.

The foreign personal holding company provisions take
precedence over the personal holding company provisions,
thus, a foreign corporation which meets both tests is
treated as a foreign personal holding company. — ' Generally,
they take precedence over the subpart F provisions. — '

6. Section 269 > , In 1943, the Congress enacted the
predecessor of §269 — ' , which grants to the Secretary the
power to disallow a tax benefit if the principal purpose of
the acquisition of control of a corporation, or of the
acquisition by a corporation from another corporation of
property with a carryover basis, is evasion or avoidance of
Federal income tax by securing the tax benefit. This provision
applies to foreign corporations as well as domestic corporations.

7. Foreign investment companies . Despite the provisions j
described above, activities perceived as abusive continued. C
One of those activities was the establishment of foreign
investment companies which sold shares widely among U.S. C
individuals. *

\
In connection with the 1962 Act, Congress attacked the f

problem of the foreign investment company which avoided
being a personal holding or foreign personal holding company
because it avoided the shareholder test by selling shares
widely to U.S. persons. These companies, often organized in
jurisdictions which did not tax their income, could invest
in securities or other passive assets and accumulate income
offshore.

¥

42/

§ 542(c)(5).

43/

— / § 951(d).

— / 1939 I.R.C. § 129.

56

The Revenue Act of 1962 adopted §§ 1246 and 1247 as an
alternative means of attacking these companies. Under §
1246 a U.S. shareholder realizes ordinary income on the sale
or redemption of his stock in a foreign investment company,
to the extent of his ratable share of its earnings accumulated
by the company after 1962 and during the time the share-
holder held the stock.

Under § 1247, a foreign investment company could, prior
to 1963, elect to have its U.S. shareholders taxed substan-
tially like the shareholders in a domestic regulated invest-
ment company. This meant that the shareholders had to
receive a distribution of 90 percent of the company's ordinary
income, and any capital gains realized by the company were
taxed to the shareholders.

8. Controlled foreign corporations . In 1962 Congress
enacted subpart F which taxes U.S. shareholders of con-
trolled foreign corporations on their proportionate share of
certain categories of undistributed profits from tax haven
activities and certain other activities of the foreign
corporation. A controlled foreign corporation is defined as
a foreign corporation in which more than 50 percent of the
voting power in the corporation is owned by U.S. shareholders.
A U.S. shareholder is a United States person who owns directly
or indirectly 10 percent or more of the voting stock of a
foreign corporation. In contrast, the ownership test for
foreign personal holding company status is ownership by five
or fewer individuals of more than 50 percent in value of the
stock of the foreign corporation. There is no minimum
ownership threshhold for a shareholder's interest to be
taken into account for foreign personal holding company
purposes.

The categories of income subject to current taxation
under subpart F are foreign personal holding company income,
sales income from property purchased from, or sold to, a
related person if the property is manufactured and sold for
use, consumption or disposition outside the country of the
corporation's incorporation, service income from services
also performed outside the country of the corporation's
incorporation, for or on behalf of any related person, and
certain shipping income. The Code refers to these types of
income as "foreign base company income." Basically, this
provision is designed to prevent tax avoidance by the diversion
of sales or other types of income to a related foreign
corporation which is incorporated in a country which imposes
little or no tax on this income when it is received by that

57

corporation since it arose in connection with an activity
taking place outside of that country. In addition, the Code
provides for the current taxation of the income derived by a
controlled foreign corporation from the insurance of U.S.
risks. Foreign base company income, income from the insurance
of U.S. risks, and certain other income are collectively
referred to as subpart F income. The Code also provides
under subpart F that earnings of controlled foreign corporations
are to be taxed currently to U.S. shareholders if they are
invested in U.S. property.

In 1976, subpart F income was expanded to include
boycott generated income, and illegal bribes or other payments
paid by or on behalf of the controlled foreign corporation

directly or indirectly to a government official. Neither of \

these later items necessarily involves tax havens. ;

Subpart F contains certain exclusions from foreign base I

company income. Income from the use of ships in foreign I

commerce is excluded to the^extent that the income is rein- [

vested in shipping assets. — ^ Foreign base company income

also does not include any income received by a controlled i

foreign corporation, if it is established to the satisfaction '

of the Commissioner that neither the creation or organization !

of the controlled foreign corporation receiving the income (

nor the effecting of the transaction giving rise to the >

income through the controlled foreign corporation has as one ^

of its significant purposes the substantial reduction of j

income taxes. !;

(<

There is also the 10-70 rule: if foreign base company ^

income is less than 10 percent of a controlled foreign f

corporation's gross income, then none of its income is •■

foreign base company income, and if more than 70 percent of i

its gross income is foreign base company income, then its t

entire gross income is treated as foreign base company i.

income. If the percentage is between 10 percent and 70 i

percent, then the actual amount of foreign base company *■
income is treated as such.

45/

— As originally enacted, shipping income was excluded

without regard to reinvestment.

58

Income derived from the insurance of U.S. risks is
subpart F income, if the controlled foreign corporation
receives premiums in respect of insurance or reinsurance in
excess of five percent of the total premiums and other
considerations it received during its taxable year. For
purposes of applying the insurance of U.S. risks rules, a
controlled foreign corporation in certain cases includes one
of which more than 25 percent of the total combined voting
power of all classes of voting stock is owned by U.S. shareholders.

9. Dispositions of stock of controlled foreign corporations .
The Revenue Act of 1962 also introduced § 1248 to the Code.

That section requires a U.S. shareholder who disposes of his
shares in a controlled foreign corporation to report any
gains on the disposition as a dividend, to the extent of the
earnings and profits of the foreign corporation accumulated
after 1962. Accordingly, this rule can be beneficial because
foreign taxes paid or accrued by the corporation may be
credited against U.S. taxes of a domestic corporation.

10. Dispositions of patents to foreign corporations .
The Revenue Act of 1962 also adopted § 1249, which requires
that gain from the sale or exchange of patents, copyrights,
secret formulae or processes, or similar property rights to

a foreign corporation by a person controlling that corporation,
is to be treated as ordinary income rather than capital
gain. The House-passed bill had included, as a category of
subpart F income, income from patents, copyrights, and
similar property developed in the U.S. or acquired from
related U.S. persons. The income to be included was royalty
income, and a constructive royalty if the foreign corporation
used the property itself. — ' The Senate rejected the House

approach because of difficulties it
constructive income. —

foresaw in determining

— / H. Rep. No. 1447, 61, 1962-3 C.B. 402, 465.

47/

— ' S. Rep. No. 1881 87th Cong., 2d Sess. 109-111 (1962)

(S. Rep. No. 1881), 1962-3 C.B. 703, 815.

59

V. Patterns of Use of Tax Havens

The figures in Chapter III, and our interviews indicate
that tax havens are being used by U.S. persons investing
overseas, and by foreign persons investing in the U.S. Not
all of this use is tax motivated. Much, however, is. Some
of the transactions are clearly legitimate, being within the
letter and the spirit of the law. Other transactions are
fraudulent, although proving the necessary willfulness to
establish a criminal case may not be possible. An overriding
problem is that the complexity of the law, the difficulties
in information gathering, and administrative problems within
the IRS often make it difficult to distinguish between the
two.

This chapter begins with a brief discussion of the ;;

distinction between tax avoidance and tax evasion. It then «

describes how assets can be transferred to tax havens in the ;

context of the Code provisions which seek to insure that the !

transfers themselves are not abusive. This chapter then

describes the activities which are being carried on in tax

havens within the context of United States tax laws which i

apply to those transactions. *

I

The transactions described begin with corporations and f

multinationals. They illustrate how existing rules are ',

utilized in a legal way. The descriptions also point out "
how, in some instances, unscrupulous taxpayers arrange their

affairs so that they appear legal, but are in fact fraudulent. 2

More abusive transactions are also described. In Chapter VI, J
transactions which have been investigated as frauds are

discussed. In Chapter VII, options for administrative and I

legislative changes are presented. These might help rationalize i

the taxation of tax haven transactions, and make the rules easier T

to administer. k

P
A. Tax Avoidance v. Tax Evasion Q

Many consider tax haven transactions evil per se
simply because there is a tax haven involved. Others look
at the tax system as something to be manipulated, viewing
tax havens as a piece in that game. They see little wrong
in using a tax haven transaction to avoid taxes that they
know are due, provided that transaction is reported. Others
will use the complexities of the law to hide income or
create deductions. In truth, often the question of whether
a tax haven transaction is legitimate or illegitimate,
whether it is tax avoidance or tax evasion, is in the eyes
of the beholder.

60

Whether or not a tax haven transaction is tax avoidance
or tax evasion or something else depends in part on how you
define those terms. In fact, the terms have probably never
been adequately defined. The term "avoidance" is partic-
ularly imprecise. Furthermore, "avoidance" has certain
connotations which in themselves seem to import evil doing
although not quite to the extent that evasion does. The
problems with distinguishing in this area and in using these
terms have been described as follows:

The term tax avoidance itself has
unfortunate connotations; it is con-
sidered as referring to an attitude
of unethical and, indeed, unlawful
behavior, although it is actually a
neutral term. In the pejorative sense
the term tax evasion should be used,
which indicates an action by which
a taxpayer tries to escape his legal
obligations by fraudulent means. The
confusion arises from the fact that
sometimes taxes are avoided — by the
use of perfectly legal measures --
against the purpose and spirit of
the law. Where this is the case,
the taxpayer involved is abusing the
law and he is blamed for it, although,
no penal measures can be taken
against him.—

Rather than attempt to define the terms with any pre-
decision, we have identified four categories of use, ranging
from completely legal (from a tax point of view) to fraud:

(1) Non-tax motivated use, transactions involving tax
havens where no U.S. tax impact results. An example is a
U.S. branch bank in a tax haven which is fully taxable by
the United States and where the source of income is not
changed.

1/

J. van Hoorn Jr., "The Uses and Abuses of Tax Havens",
Tax Havens and Measures Against Tax Evasion and Avoid-
ance in the EEC , Associated Business Programs (London,
1974).

61

(2) A transaction which has a tax effect, but which is
completely within the letter and the spirit of the law. An
example is the formation of a subsidiary in a tax haven to
conduct a shipping business or the formation of a subsidiary
in a tax haven to conduct a banking business, where all of
the necessary functions are performed by the tax haven
entity in the tax haven.

(3) Aggressive tax planning that takes advantage of an
unintended legal or administrative loophole. An example of
this might be establishing a service business in a tax haven
to provide services for a branch of that business located in
a third country. A further example might be the use by a
multinational corporation of artificially high transfer
pricing to shift income into a tax haven. Often, the parties
know full well that, if the transaction is thoroughly audited,
a significant adjustment will probably be made. They rely

on difficulties in information gathering and on complications
to possibly avoid payment of, or at least to postpone payment
of, some tax.

(4) Tax evasion; an action by which the taxpayer tries
to escape his legal obligations by fraudulent means. This
might involve simply failing to report income, or trying to
create excess deductions. This category can also be broken
down into two subcategories: (a) evasion of tax on income
which is legally earned, such as slush funds; (b) evasion of
tax on income which arises from an illegal activity, such as
trafficking in narcotics.

In this chapter, patterns of use of tax havens are
described. At times, the transactions are so complicated
and the information gathering problems so difficult that it
may not be possible to distinguish between the various
categories. The lines become murky because the law is murky
and the information is incomplete.

B. Transfers to a Tax Haven Fntity

United States persons doing business abroad continue
to use tax havens in traditional ways. They will form a
corporate entity in a tax haven and use it to carry out
their foreign operations. The use of a tax haven company
has significant advantages. From a U.S. tax point of view,
it may give the benefit of deferral or enable a U.S. parent
corporation to absorb excess foreign tax credits. It may
also decrease the overall foreign tax burden of a taxpayer
or affiliated group of corporations, and may allow a company
to do business overseas free of currency or other controls.
Generally, in order to use a tax haven entity, property must
be transferred to it.

62

1. Transfer Pricing

United States taxpayers may attempt to shift assets and
income to low or no tax countries from high tax countries
through transfer pricing. Where this shifting is at arm's
length and within the guidelines set by the IRS and the
courts, it is perfectly legitimate. There often are honest
disagreements as to what is an appropriate charge or price.
This happens very often because taxpayers find the §482
regulations difficult to deal with. If the price is too
high, the IRS can allocate the income. Transactions generally
not permissible under IRS regulations and for which an
allocation may therefore be appropriate can take numerous
forms, as follows:

a. Payment of interest from the U.S. or another high
tax country to a tax haven affiliate at above market rates.

b. Payment of royalties from the U.S. or other high
tax country to a tax haven affiliate at higher than fair
market value rates.

c. Sale of property by an entity located in a high tax
country to an affiliate in a tax haven at a low price,
followed by a sale by the tax haven entity at a high price.

d. Transfer of income producing assets, such as stocks,
bonds or other securities, or patent rights, from a U.S.
person or from any affiliate of a U.S. person in a high tax
country to an affiliate in a tax haven at a low cost.

e. Payment of management, service or other fees to a
related entity which has not in fact performed services; or
payment for services performed but at a price above fair
market value.

f. Leasing of tangible property to a tax haven entity
for less than fair market value.

g. Transfer of components for less than market value,
to a tax haven affiliate for assembly, followed by a sale of
the finished product at a high price.

In many cases, in addition to shifting assets to the
tax haven entity, the transactions will result in deductions
for the high tax country entity which is income shifting.
For example, the payment of interest by a U.S. corporation

63

to a foreign affiliate results not only in the shifting of
the interest to the tax haven, but in a deduction for interest
expense to the tt.s. company. Likewise, if a U.S. company
develops technology, deducts the development expenses, and
then transfers the technology to the tax haven affiliate
for sublicensing or for use in its trade or business without
adequate compensation, not only is income-producing property
transferred to the tax haven entity, but the U.S. affiliate
has been able to take deductions for expenses without having
to realize the income that accrues from the expenses.

A somewhat related problem is the failure of a U.S.
company to properly allocate to a tax haven affiliate expenses
it incurs for that affiliate. For example, a U.S. company
may provide managerial services for a tax haven affiliate,
and fail to charge for them. In addition, it may fail to
allocate expenses which it incurs and which are, in reality,
for the tax haven affiliate. A greater foreign tax credit
may be available because of this failure to properly allocate
expenses.

2. Transfers of Assets Other than by Transfer Pricing

Another method for transferring property to a tax haven
entity is by a tax free reorganization or other exchange.
In the case of transfers from the U.S., the general non-
recognition provisions of the Code operate only if the
transferor receives a ruling from the IRS that the exchange
did not have as one of its principal purposes the avoidance
of Federal income taxes.—

a. Transfers to Tax Haven Corporations--Scope of §367.

Section 367 was originally intended to prevent taxpayers
from permanently circumventing the tax^ordinarily payable on
the disposition of appreciated assets.— When created, the
tax avoidance concept was thus of limited scope.

-/ § 367.

-^ See H.R. Rep. No. 708, 72d Cong., 1st Sess. 20 (1932);
and S. Rep. No. 665, 72d Cong., 1st Sess. 26-27 (1932).

To illustrate the loophole they sought to close, the
House and Senate gave this example in their report:

A, an American citizen, owns 100,000 shares of
stock in corporation X, a domestic corporation, which
originally cost him $1,000,000 but now has a market
value of $10,000,000. Instead of selling the stock

64

The IRS, however, expanded this scope by looking to
other consequences of asset transferral. In addition to the
complete avoidance of tax on realized appreciation from
investment assets, the IRS considered the potential for
temporary deferral of tax and also the deferral of tax on
other income produced by the transferred asset, e.g. , interest
and dividends, in determining whether a tax avoidance purpose
was present. Application of the tax avoidance concept was
thus enlarged to include both the nature of the transferred
assets and the nature of their subsequent use.

The breadth of this inquiry was reduced by the IRS in
1968, in response to the 1962 enactment of subpart F.-^
The IRS announced, in Revenue Procedure 68-23,-^ that its

outright, A organizes a corporation under the laws of
Canada to which he transfers the 100,000 shares of
stock in exchange for the entire capital stock of the
Canadian company. This transaction is a nontaxable
exchange. The Canadian corporation sells the stock of
corporation X for $10,000,000 in cash. The latter
transaction is exempt from tax under the Canadian law
and is not taxable as United States income under the
present law. The Canadian corporation organizes
corporation Y under the laws of the United States and
transfers the $10,000,000 cash received upon the sale
of corporation X's stock in exchange for the entire
capital stock of Y. The Canadian corporation then
distributes the stock of Y to A in connection with a
reorganization. By this series of transactions, A has
had the stock of X converted into cash and has it in
complete control.

When this provision was adopted, Canada was considered
to be a tax haven.

4/

- See J. Sitrick, "Section 367 and Tax Avoidance: An

Analysis of the Section 367 Guidelines" 25 Tax L. Rev.
429 (1970).

Mr. Sitrick, formerly of the Office of Tax Legislative
Counsel (International), states that

. . . while the importance of section 367 was
reduced considerably by reason of the 1962 legislation,
the section retains importance in transactions with
which the provisions of subpart F were not intended to
deal directly. [25 Tax L. Rev, at 442.]

-/ 1968-1 C.B. 821.

65

concern would be limited to the nature of the assets transferred,
i.e., to their inherent potential for income and gain.—

The IRS also announced in Revenue Procedure 68-23, at
§3.02(1), that when the transferred assets are "...to be
devoted by the transferee foreign corporation to the active
conduct, in any foreign country, of a trade or business...
[the transaction will ordinarily receive favorable consideration]
Although apparently in conflict with the new policy to leave
consideration of post-transfer use to subpart F, adoption of
this "active business" criterion was not intended to provide
a means for determining whether tax avoidance would flow
from the post-transfer activity itself. Rather, it was
included to test the avoidance potential of the individual
asset, the thought being that property used in an active
trade or business would not be transferred with a principal
view to the realization of its appreciation_or enjoyment of
its income outside the taxing jurisdiction.— Therefore,
the active business requirement dpes not impinge on the
deferral permitted by subpart F.—

In 1976, the Congress amended § 367 to remove the pre-
transaction filing requirement .in all cases, and the ruling
requirement in certain cases.— None of the statutory ■■» ,
changes significantly clarified the meaning of tax avoidance. — '^

-'^ See Rev. Proc. 68-23, §§ 3. 02 ( 1 ) ( a ) -( d ) (describing
certain "tainted" assets), § 3.01(2), and § 3.03(l)(a)

-^ See also § 3 . 02( 1 ) (a) ( iv) of Rev. Proc. 68-23.

— Section 367 clearance will not be granted if property
transferred to a foreign corporation will be used to
conduct a trade or business in the United States. To
this extent, the subsequent use test retains vitality
under § 367.

-' Tax Reform Act of 1976, § 1042.

10/

H.R. Rep. No. 94-658, 94th Cong., 1st Sess. 239-40 (1976),
1976-3 C.B. (Vol. 2) 931-2; and S. Rep. No. 94-938,
94th Cong., 2d Sess. 261-2 (1976), 1976-3 C.B. (Vol. 3)
299-300.

66

As presently construed, § 367 is of limited utility in
tax haven related tax administration. While it does prevent
the transfer of certain assets with income-producing potential,
it will not prevent the transfer of an active business which
may then be conducted free of subpart F. For example, a tax
free transfer can be used to enable a U.S. manufacturer to
take advantage of a tax exemption granted by one country to
attract manufacturing and the low rates of tax afforded by a
tax haven on passive investment income.

Section 367 can be used only to deny non-recognition
for a transfer to a corporate entity, and therefore its
impact is limited to permitting a tax (often a capital gain
tax) on appreciation. In many cases it is unclear that
anything of value has been transferred. For example, an
engineering company which is to perform services in the
Middle East may be able to form a subsidiary corporation in
a tax haven without a §367 ruling. Arguably, under Revenue
Ruling 79-288, — ^ no ruling would be required if, before the
transfer, the parent had no rights under the tax haven's law
to use, and protect from unauthorized use, the parent's
name. However, a ruling may be required for the transfer of
the active business or for the transfer of goodwill.

b. Transfers Not Reorganizations

Section 367 does not affect a transfer to a trust, a
partnership, or a corporation where the reorganization
provisions are not applicable in any case. Instead, the §
1491 excise tax might apply.

Like § 367, § 1491 was intended to prevent taxpayers
from transferring appreciated property to foreign entities
to avoid United States tax on the gain. Today, § 1491 is
broad, covering almost all transfers to almost all foreign
entities. There are, however, exceptions which can be
abused. Further, like § 367, the IRS does not interpret §
1491 as taking into account post-transfer use of the assets
transferred in determining whether it operates. Therefore,
if the transfer fits one of the exceptions, the § 1491
excise tax does not apply.

Legislative exceptions to the § 1491 tax are provided
(1) for transfers to a tax exempt organization, (2) if the
transfer is not in pursuance of a plan having as one of its
principal purposes the avoidance of Federal income taxes,
(3) if § 367 applies to the transfer, or (41 ,if an election
to recognize gain on the transfer is made. — '

— / 1979-2 C.B. 139.
— / § 1492.

67

Attempts have been made to avoid or evade §1491 by the
following transactions:

1. A transfer of unappreciated or slightly appre-
ciated property, or a transfer of slightly appreciated
property with respect to which a § 1057 election has been
made.

2. A transfer to a friendly foreign foundation which
is a tax exempt organization.

3. A transfer of ordinary income property (subject to
the excise tax, but at a lower rate of tax than the ordinary

rates) . ^

4. A transfer at death by operation of law rather than ^
by devise. «

5. A transfer through a conduit, such as a shell U.S.
corporation which has no assets with which to pay the § 1491
tax, or through a friendly non-resident alien to a trust for
the benefit of the U.S. transferor or his family.

Some of these transactions are fraudulent. The use of
a foreign intermediary to pass property to a foreign trust,
for example, is a willful attempt to evade or defeat tax.
The willful failure to file the required return (Form 926)
is punishable under § 7203. The same is true of the transfer
to a friendly foreign foundation where the real intent is
that the property will be used for the benefit of the transferor
or his family.

To the extent that the transactions described above are
permitted by the Code, they reflect Congressional policy
determinations. For example, the fact that § 1491 is
avoided by a § 1057 election or the realization of a small
amount of income reflects a Congressional policy of protecting
the U.S. tax on the gain inherent in the property. Not
subjecting to U.S. tax the income earned from the property
after transfer is a deferral issue, and occurs because of
Congressional policy decisions as to the scope of the trust
rules or other anti-avoidance rules.

1

68

Similarly, § 1491 will not apply to a transfer to a
foreign trust by a non-resident alien who then becomes a
United States resident. Section 1491 can also be avoided by
a United States expatriate transferring property after
renouncing citizenship. Both gaps could be closed by legislation
subjecting at least some transfers to §1491. Once again,
however, any problems are caused by Congressional decisions
as to the scope of the United States taxing jurisdiction.

C. Transactions Through a Controlled Entity

Today, major corporations conduct varied activities in
tax havens. During consideration of the 1962 Revenue Act,
the IRS described certain categories of tax avoidance devices
used by U.S. taxpayers doing business overseas. Some appear
to be used today and in some cases their use has grown;
others have been substantially eliminated. Corporations
continue to divert income to foreign subsidiaries which
engage in no real activity abroad. They continue to organize
foreign subsidiaries to carry on the same type of business
activity previously conducted by the domestic parent and to
divert income through improper pricing arrangements and
through the transfer of valuable income producing assets,
both tangible and intangible, to tax haven entities. Diversion
of income through improper expensing also continues. Foreign
transportation and reinsurance still continue to a significant
degree.

Patterns of use by industry groups is apparent. For
example, the petroleum industry makes significant use of
tax havens. It uses them by forming companies in tax havens
to carry out the traditional functions of shipping and
refining and selling petroleum, and for newer activities
including transshipping.

The insurance industry also continues to make extensive
use of tax havens. Foreign insurance companies doing business
in the United States often have a Bermuda or Cayman subsidiary
through which they reinsure risks written in the United
States. Many United States multinational companies have
captive insurance subsidiaries located in Bermuda.

The construction industry and other service industries
are making increasing use of tax havens. The growth in
these industries appears to have been the fastest of any
industry group.

69

Tax havens are an overwhelming factor in the shipping
industry. Many United States companies own shipping companies
formed in tax havens (most often Liberia or Panama).

Commercial banks have extensive operations in tax
havens, operating there mostly through branches, although
some U.S. banks have subsidiaries in tax havens. As the
data in our tax haven levels estimate show, this use has

deal of

grown enormously in the past .few years, with a great
the growth in the Bahamas. — '

The heavy equipment industry also tends to utilize
sales companies in tax havens. In a few cases manufacturing
or assembly operations have been conducted in tax havens.
Most manufacturing and assembly operations, however, are
conducted in low cost areas offering tax incentives to
attract industry, such as Taiwan, Korea, the Phillippines,
Ireland, and Puerto Rico, which were generally not addressed
in this study. At times, a tax haven corporation is formed
to make the investment in the manufacturing tax haven.

1. Tax Planning — Minimizing Tax and Maximizing the
Foreign Tax Credit

United States taxpayers use tax havens in legal tax
planning for one of three purposes or a combination of
them: (1) to minimize United States tax on a transaction or
on investment income; (2) to increase foreign source income
free of foreign tax to enable the taxpayer to credit more
foreign income taxes; and (3) to minimize foreign taxes
which might otherwise be imposed on a transaction.

Tax haven entities can be used to minimize taxes. If
the goal is to avoid U.S. tax on the income from a transaction,
the transaction would have to be structured to avoid the
application of subpart F and the foreign personal holding
company rules. It would also have to comply with the §482
pricing regulations. Prior to 1976, foreign trusts could be
used for this purpose, but this use has been substantially
curtailed, although not totally eliminated. Avoiding or
deferring U.S. tax on the income might be accomplished by,
for example, keeping within the de minimis exception from
subpart F, or by conducting transactions which subpart F
does not tax.

— ^ See Chapter III, supra. See New York Times, Friday,
March 24, 1977, at Al.

70

In some tax haven transactions may result in U.S. tax
liability under subpart F or the foreign personal holding
company provisions. In other cases, the IRS may shift
income to or from the tax haven entity under the intercompany
pricing rules and accordingly minimize the tax avoidance
potential of the haven entity. In some cases, however,
unless the income is treated as U.S. source income, taxing
the tax haven entity's income to the U.S. parent under
subpart F has no real U.S. tax effect, because the U.S.
parent is in an excess foreign tax credit position and
foreign taxes imposed on non-tax haven income will in any
event offset any U.S. tax which may be imposed on the subpart
F income. In fact, at times, a planning goal is achieved if
income can be shifted from the United States to a tax haven
so as to absorb excess credits from taxes paid to high tax
countries. Some practitioners believe that most large
multinational companies are at or near an excess credit
position, and that any changes to tax more tax haven income
will affect small companies, not the larger ones. Nevertheless,
the larger companies are using tax havens to significant
advantage.

A U.S. taxpayer can credit foreign taxes on a dollar-for-
dollar basis against its U.S. tax imposed on foreign source
income. The limitation is computed on a worldwide basis so
that taxes paid to high tax countries can offset U.S. taxes
on income earned in low tax countries such as tax havens.
The foreign tax credit is available up to the U.S. tax rate.
If the foreign taxes paid or accrued in a taxable year
exceed the U.S. rate, the excess can be carried back or
carried forward for a limited number of years. If they
cannot be used within that period, they are lost.

Assume, for example, that U.S. corporation X has taxable
income of $10 million, $5 million from U.S. sources and $5
million from Country A. Country A imposes a tax of 50
percent, or $2.5 million in this case. X's U.S. tax before

71

credit is $4.6 million (46% of $10 million). X's foreign

tax credit limitation is $2.3 million ($5,000,000 ^ $10,000,000

X $4,600,000) which leaves X with a $200,000 excess credit.

Its worldwide tax burden is $4.8 million. If this same

pattern recurs annually so that X will not be able to use

the excess credits in other years, then X has an additional

cost of $200,000 per year.

Assume, however, that X can structure its transactions
to convert $1.0 million of its U.S. source income to foreign
source income in a tax haven which does not tax that income.
For example, X could form a Bahamian company and sell through
it to generate foreign base company sales income, or it
could transfer working capital to be invested by the Bahamian
company. In either case, X would be taxed under subpart F
on the income of the Bahamian company. Thus, X is still
taxed by the U.S. on $10 million and its U.S. tax before
credit is still $4.6 million. However, X's foreign tax
credit limitation is now $2.76 million ($6,000,000 ^ $10,000,000
X $4,600,000). X can therefore credit its entire Country A
tax of $2.5 million bringing its worldwide tax burden down
to $4. 6 million.

If the above transactions are not conducted at arms
length the income might be reallocated to the U.S. under
§482. Also, the IRS may have an argument for disregarding
the tax haven company under §269. If, however, the transactions
cannot be restructured a tax advantage has been gained.

The same worldwide tax reduction can be accomplished by
reducing foreign taxes, which is at times easier than minimizing
united States taxes. Often foreign laws are not as well
developed as United States laws and foreign tax administrators
may not be as sophisticated as United States tax administrators,
or have the resources which are available to the United
States. If foreign taxes can be minimized so that they do
not exceed the inited States foreign tax credit limitation,
a cost of doing business has been reduced. Thus, an alternative
approach in the above example would be to try to shift
income from Country A to the tax haven.

72

2. Holding Companies

One of the most significant uses of a tax haven corporation
is as a holding company. Holding companies are used to
control other companies through stock ownership, as investment
vehicles, or to collect income such as dividends, loan
interest, and royalties or licencing fees. The company will
either distribute the funds to the parent or it will reinvest
the funds, in some cases lending them to affiliates.

Generally, the company will be established in a tax
haven which imposes little or no income tax on the earnings
of the company, and which imposes no withholding tax on the
distributions and payments it will make. If possible, a tax
haven with a widespread treaty network will be used so that
payments to the holding company will incur relatively low
rates of tax in the source country. A country with a special
tax regime for holding companies might be chosen. Thus,
many holding companies are established in Switzerland,
Luxemborg, Liechtenstein, or the Netherlands (which becomes
a tax haven by reason of its treaty network).

The holding company is formed in the tax haven, and
assets are transferred for nominal consideration or in a tax
free reorganization transaction. The company then either
collects dividends, in the case of stock, or in the case of
patents, relinquishes these rights to other foreign corporations
and receives royalties.

Initially, the Congress addressed holding company abuse
by individuals and sought to eliminate that f^i^se by the
foreign personal holding company provisions. — ' Widely held
companies, however, were free to obtain the benefits of
deferral by the formation of a holding company in a tax
haven. In 1962, the Congress sought to prohibit corporate
holding companies by including, as a category of-,subpart F
income, foreign personal holding company income. — In
doing so, they recognized "the need to maintain active
American business operations abroad on an equal competitive
footing with other operating businesses in the same countries",
but saw "no need to maintain the deferral of U. S. tax where
the investments are portfolio types of investments or where , , ,
the company is merely partially receiving investment income." —

\^/

§§ 551-558.

1^/ § 954(a)(1)

16/

H. Rep. No. 1447, 87th Cong., 2d Sess. 62 (1962); S. Rep.
No. 1881, 87th Cong., 2d Sess. 82 (1962).

73

For subpart F purposes, foreign personal holding
company income is defined as that term is defined for ,-. .
purposes of the foreign personal holding company provisions, — '
but with numerous modifications, generally intended to
exclude actual business income and income received from a
related company in the same country as the receiving company.

There is still significant use of tax haven holding and
investment companies. In 1976, controlled foreign cor-
porations formed in tax havens and classified as holding
companies and other investment companies reported assets of
$8.3 billion. This figure represents more than half of the
worldwide assets of such companies.

The foreign personal holding company provisions may be
circumvented by transferring the income producing assets to
an active business rather than to a holding company. Under
subpart F, if the foreign base company income of a con-
trolled foreign corporation is less than 10 percent of gross
income, no part of the gross income for the taxable year is
treated as foreign base company income. Accordingly, if a
substantial non-base company income producing business is
being conducted, passive income can be sheltered, provided
the passive income is less than 10 percent of the gross
income of the controlled foreign corporation. The amount
sheltered can be large. For example, if a foreign subsidiary
has gross income of $10 million, none of which is base
company income, over $1 million in passive income could be
shifted to it and sheltered. In fact, there are base
companies with over $1 billion in gross non-base company
income. Such a company could shelter more than $100 million
in passive income.

A holding company can also be used to advantage to
change U.S. source income into foreign source income to
absorb excess foreign tax credits. For example, X, a U.S.
multinational corporation, has cash invested in CD's in a
U.S. bank. The income is U.S. source income taxable in the
U.S. The interest income could be turned into foreign
source income simply by placing the cash in a foreign bank.
However, there is a separate foreign tax credit limitation
for bank interest income to prevent just such planning.
Instead, X contributes the cash to Y, its tax haven holding
company. Y deposits the cash in a foreign bank. The
interest Y receives on the deposit is foreign personal

il/ § 553.

74

holding company income taxable to X under subpart F, but as
a dividend not subject to the separate limitation for interest.
Uhited States source interest income has been converted into
foreign source income against which foreign taxes may be
credited. This transaction is perfectly legal, and is done
often.

Some persons have attempted to avoid paying U.S. tax on
the personal holding company type income of their foreign
corporation, circumventing the personal holding company
income provisions by claiming that the income of the foreign
corporation is derived from the active conduct of a banking
or financing business, one of the exclusions from foreign
personal holding company income. — ' In many cases the
schemes are fraudulent. In others, however, the issue is
not so clear because the form of establishing a bank and
engaging in the banking business is followed.

For example, in an attempt to create a colorable claim
of entitlement to this exclusion, an individual or a company
organizes a bank or finance company in a friendly tax haven
jurisdiction, such as St. Vincent, that has little or no
control over its local banks. The bank may engage in various
activities. For example, it m^y lend funds to related
parties and receive the income free of tax. It may also
engage in some limited banking activity, such as selling
CD's to foreigners, and then relending the proceeds for use
in its controlling shareholders business or for use by
others. If the taxpayer is successful in avoiding audit,
or, in the unlikely event that he is sustained in the
argument that his foreign corporation is engaged in the
banking business, the personal holding company type income
can be accumulated in the tax haven free of tax. St. Vincent
shell banks have allegedly been used to defraud banks and
other businesses in the United States.—'

3. Sales Activities

A tax haven corporation may be used as a sales company.
The sales company may buy from or sell to affiliates or may
engage in sales only with unrelated persons. Transactions
with affiliates will frequently be priced to minimize the
tax liability of the affiliated group. Generally, this
means that the sales will be structured to maximize the
profit of the tax haven affiliate.

— / §954{c)(3)(B).

19/

— ' See New York Times, Tuesday, Oct. 21, 1980, D-5.

75

Prior to the Revenue Act of 1962, U.S. companies had
established a significant number of sales companies in tax
havens. The Congress sought to limit this use by including
in the U.S. shareholder's income "foreign base company
sales income". — ' Foreign base company sales income is the
income of a controlled foreign corporation derived from (1)
the selling of property purchased from a related person, or
(2) the buying of personal property for sale to a related
person, if the property is produced outside the country
under the laws of which the controlled foreign corporation
is created or organized and the property is sold for use
outside of that country. — ' Commission income from those
sales is also included.

The crucial element in foreign base company sales *J

income is a purchase from or a sale to a party related to \

the controlled foreign corporation. If the transactions are 5

with unrelated parties, there is no foreign base company *

income. 2

under this provision, income earned by a Bahamian «i

corporation from the sale to unrelated Italian customers of 2

goods purchased from a German affiliate would be foreign il

base company sales income. Income earned by the Bahamian 2

corporation from the sale to unrelated Italian customers of »

goods purchased from an unrelated German supplier would not £

be foreign base company sales income. d

1

Despite subpart F, some sales activity continues in tax J

havens. Attempts may be made to circumvent subpart F. A -

U.S. company can arguably avoid the foreign base company ^

sales income provisions by licensing an unrelated foreign J

company to manufacture goods, and having a tax haven subsidiary 1

purchase those goods for sale to customers in a third country. /

The 10 percent de minimis exception can be used to ;J

shelter enormous amounts of income. Foreign tax haven ^

corporations wholly owned by a U.S. corporation have had
gross income of more than $1.0 billion from purchasing and
selling from and to unrelated persons. The companies also
earned shipping income and had passive investment income.
There was no subpart F income because the sales activity was
with unrelated parties, the transportation income was exempt,
and the passive income was sheltered by the 10 percent de
minimis exception.

— / § 954(a)(2).
— / § 954(d)(1).

76

In the petroleum industry, trading companies have been
formed by the major integrated companies, and also by small
oil companies commonly known as oil resellers, which do not
have production of their own. The majors will often use the
trading companies for dealing with unrelated parties. If
the trading company is actually engaged in this business,
the activity is specifically outside the scope of subpart F.
In many cases, however, all of the decisions regarding the
purchases and sales by the trading company are made in the
United States. In some cases, the business functions of the
parent are duplicated by the foreign subsidiary. There may
be two buying and selling organizations, one engaging in
domestic business and the other in foreign with respect to
the same oil. It is difficult to determine who is really
doing what for whom. Similar patterns may exist in the
grain industry.

While trading companies are legitimate tax planning
tools, fraudulent arrangements may be structured to look
like trading companies. Often, information gathering problems,
including lack of access to tax haven records, make it
difficult to prove criminal fraud. Transactions are, at
times, arranged with friendly third parties to avoid purchases
and sales with a related party. For example, oil company X
forms subsidiary corporation Y in a tax haven. Y is to
engage only in the buying and selling of foreign oil.
Usually, Y buys foreign oil from an unrelated party and
sells that oil to an unrelated third party. It is believed,
however, that at times swapping arrangements are entered
into under which Y buys from an unrelated party and sells to
an unrelated friend at a high price. The friend then sells
to X, the U.S. parent, at its cost or at cost plus a small
profit. In reality, Y has sold oil to X at a price which is
too high. If the facts were known, the IRS could reallocate
the income to X under § 482, and Y would have subpart F
income. Because of the frequency of transactions, the
fungibility of oil, and the lack of adequate records, it is
difficult for the IRS to establish the substance of the
transaction.

Trading companies were involved in the so called "daisy
chain" scheme that was used to attempt to avoid the Depart-
ment of Energy price control regulations. In one case, a
U.S. company bought domestic oil and sold it to a tax haven
corporation, which the U.S. company claimed was not an
affiliate. The oil was sold through a number of different
companies, and then the same oil was purchased by the U.S.
corporation's foreign subsidiary, which sold it to other
parties and then back into the United States. The initial

77

sale by the U.S. company to the tax haven company was at a
low controlled price. The oil was eventually sold back into
the United States at the higher world price. The substantial
markup was left in the offshore companies. The persons who
control the U.S. company also control the tax haven company,
but evidence which can be introduced in a court is not
available.

The foreign base company sales income provisions may
be avoided by structuring an entity as an assembly operation
rather than as a sales company. Foreign base company sales
income does not include income from the sale of property
manufactured, produced, grown or constructed by the controlled
foreign corporation in whole or in part from property which
it purchased. — ^ Property is considered manufactured,
produced, grown or constructed by the subsidiary if it is
substantially transformed prior to sale or if the property
purchased is used as a component of the property sold. — '
The substantial transformation test is subjective. The
component test in the regulations can be met through a cost
test or a subjective test. Purchased property is used as a
component if the operations conducted by the selling corporation
in connection with the property purchased and sold are
substantial in nature and^ace manufacturing, production or
construction of property. — ' In addition, the operations
of the selling corporation, in connection with the use of
the purchased property as a component part of the personal
property which is sold, is considered the manufacture of a
product if, in connection with the property, conversion
costs of the corporatioRc-are 20 percent or more of the total
cost of the goods sold. —

1.954-3(a) (4).

1.954-3(a) (4) (ii) and (iii).

1.954-3(a) (4) (iii) .

For an example of the application of the manufacturing
exception see, Dave Fischbein Mfg. Co. v. Commissioner ,
59 T.C. 338 (1972), acq . 1973-2 C.B. 2, in which a bag
assembly operation was conducted by a Belgian corporation
wholly owned by a U.S. corporation. The Belgian company
bought components from its U.S. affiliates, and some
minor parts locally, assembled them in Belgium, and then
sold them worldwide. The court simply disagreed with
the contention of the IRS that the activities were not
manufacturing.

22/

Treas.

Reg.

§

23/

Treas.

Reg.

§

24/

Treas.

Reg.

§

25/

•^1 r^

78

A U.S. company can, therefore, form a subsidiary in a
tax haven, sell components to the subsidiary which assembles
them, and take the position that no foreign base company
sales income is earned on the sale of the property which
includes the components. The 20 percent safe harbor is
relatively easy to meet. In addition, the subjective tests
in the regulations are difficult for the IRS to deal with
because of problems of access to books and records, personnel,
and the manufacturing plant itself.

The assembly operations may be subject to scrutiny
under the intercompany pricing rules. The IRS may reallocate
income from_sales between the haven subsidiary and its
affiliates. — ' In addition, allocations might be made on
the grounds that an affiliate is performing services for the
tax haven subsidiary — ' or that an affiliate has licensed
intangibles (such as a_trademark) to the subsidiary without
adequate compensation. — ^ There are, however, information
gathering problems in applying these rules.

Also included in foreign base company sales income is
income of a branch of a controlled foreign corporation
operating outside of the country in which the controlled
foreign corporation is incorporated, if the use of the
branch has substantially the same tax effect as if the
branch were a wholly owned subsidiary corporation of the
controlled foreign corporation. — ' The regulations assume a
substantially similar tax effect if the branch is taxed at a
somewhat lower rate than it would have-been in the country
where the subsidiary is incorporated. — ' Under this rule,
if a tax haven company is organized in Panama, and has a
selling branch in a low tax country, the branch rule will
operate, because Panama imposes a corporation tax on business

— / § 482; Treas. Reg. § 1 . 482-2 (e )( 1 )( ii ) .

— / Treas. Reg. § 1.482-2(b).

— / Treas. Reg. § 1.482-2(d).

— / § 954(d)(2).

— / Treas. Reg. § 1. 954-3 (b) (1 ) .

79

income from Panamanian sources. If, however, the base
company is formed in the Cayman Islands (which has a zero
rate of tax) it can establish a branch^in a second country
and not be subject to the branch rule.— ^

A pattern of doing business has developed to take
advantage of the branch rule and the 10 percent foreign base
company de minimis rule. A U.S. company wishing to take
advantage of a tax holiday offered by a country which is
trying to attract manufacturing plants, forms a subsidiary
in a tax haven with which the United States has a tax treaty
and transfers to it the requisite capital and technology.
The tax haven company constructs the manufacturing plant in
the tax holiday country and its production is exported and sold
to unrelated persons. Assuming the initial transfer qualifies
under § 351, a favorable § 367 ruling would ordinarily be
issued because the property will be used in the active
conduct of a trade or business.— ^ The manufacturing profits
are not taxed to the U.S. parent because they are not foreign
base company income. The sales profits are not foreign base
company sales income because of the local manufacturing
test. In addition, the earnings can be reinvested in the
tax haven substantially free of tax if the income from those
earnings is less than 10 percent of the foreign corporation's
gross income. The tax haven entity is used because while
the tax holiday country does not tax the export manufacturing
profits it would tax the passive income earned on retained
earnings at a high rate. The tax haven may tax these earnings
but at a very low rate of tax. The retained earnings of the
tax haven company might also be reinvested in active business
assets free of tax. The tax effect is the avoidance of the
tax holiday country tax, not necessarily U.S. tax.

4. Services and Construction

The service and construction industries have increased
.their use of tax haven entities enormously. The data demon-
strate rapid growth in assets invested through tax haven
entities in both of these industries. The growth greatly
exceeds the growth in other industries, despite subpart F's
application to services and the existence of detailed § 482
allocation regulations applying to services.

31/

— ' Of course, if the second country is a high tax country,

then to the extent that the branch is subject to tax in

that second country there is no overall tax avoidance.

However, by careful planning, some second country

tax can often be avoided.

— / See Rev. Proc. 68-23, 1968-1 C.B. 821, 823.

80

For 1976, earnings of controlled foreign corporations
formed in the tax havens are estimated at $330 million in
the service industries and over $500 million in construc-
tion. These companies are estimated to have assets of $2.4
billion and $2.2 billion respectively. In 1976, controlled
foreign corporations formed in the tax havens held 23 percent
of the worldwide assets of service companies and 42 percent
in construction. These figures represent an increase from 11
percent and 26 percent respectively, from 1968.

Subpart F income includes foreign base company services
income. Foreign base company services income is defined as
income from the performance of technical, managerial, engin-
eering, architectural or like services outside of the country
of incorporation of the controlled foreign corporation, if
such services are performed for, or on behalf of, a related
person. — ^ Services which are performed for, or on behalf
of, a related person include (i) direct or indirect compensation
paid to a controlled foreign corporation by a related person
for performing services, (ii) performance of services by a
controlled foreign corporation which a related person is
obligated to perform, (iii) performance of services with
respect to property sold by a related person where the
performance of services constitutes a condition of sale, and
(iv) substantial assistance contributing to the performance
of the services by the controlled .foreign corporation furnished
by a related person or persons. — ' A related party provides
substantial assistance to a controlled foreign corporation
if the assistance furnished provides the controlled foreign
corporation with the "skills" which are a principal element
in producing the income from the performance of the services
or the cost to the controlled foreign corporation of the
assistance is 50 percent or more of the total cost to the
foreign corporation of performing the services; assistance
is not taken into account unless it assists thej-subsidiary
"directly" in the performance of the services. — '

Despite these provisions, little income tax has been
collected from the service or construction industries in
havens. According to IRS 'statistics, includable income of
controlled foreign corporations in the services industry was

— / § 954(b) (3).

— / Treas. Reg. § 1 . 954-4 (b )( 1 ) .

— / Treas. Reg. § 1 . 954-4 (b) ( 2 ) ( i i ) (b ) and (e)

81

approximately $5.7 million in 1975 and in the construction
industry was approximately $2.6 million.

The foreign base company services income concept was
drafted with manuf acturinq-related services in mind. Congress
stated that "as in the case of sales income, the purpose
here is to deny tax deferral where a service subsidiary is
separated from manufacturing or similar activities of a
related corporation and organized in another country primarily
to obtain a lower rate of tax for the service income." — '
Today, the services which appear to be making the greatest
use of tax havens are independent construction, natural
resource exploration, and high technology services, which
are not related to manufacturing. A portion of a business
which is conducted in the U.S. can simply be excised from
the U.S. business and transplanted to a tax haven. The
services are not being performed for a related party, but
rather are being performed for unrelated parties. The income
is being accumulated free of tax.

The problems with the service rules are generally due
to the approach taken by the Congress, which, in effect,
mandates regulations requiring difficult line drawing. It
is unclear what facts and circumstances are necessary for
the IRS to assert that substantial assistance has been
rendered to the foreign subsidiary. The regulations do not
establish guidelines, other than two examples which are not
particularly helpful. One example indicates that if a
contract for the provision of services is supervised by
employees of the U.S. parent corporation who are temporarily
on loan to the subsidiary, then substantial assistance is
rendered to the subsidiary by the related person, and the
income from the^oerformance of the contract is foreign base
company income. — If, however, the contract is supervised
by permanent employees of the subsidiary, and the U.S.
parent only provides clerical assistance, then such assistance
is not substantial and income from the contract is not

— / S. Rep. No. 1881, at 84, 1962-3 C.B. 703, 790.
— / Treas. Reg. § 1 . 954-4 (b) ( 3 ) example (2).

82

38/
foreign base company services income. — ' The example also

indicates that if permanent employees of a controlled foreign

corporation oversee a contract with no substantial assistance

rendered by a related person, then no foreign base company

services income arises from the performance of the contract.—'

The determination of whether an employee is permanent
or temporary presents a very difficult factual issue. By char-
acterizing employees as permanent employees of a controlled
foreign corporation, a U.S. shareholder can take the position
that the transactions in question do not produce foreign
base company services income.

The factual issue of what constitutes substantial
assistance has arisen in connection with a number of services,
including offshore drilling. In a prototype case, a U.S.
parent establishes a foreign subsidiary in a tax haven to
conduct offshore drilling operations outside of the subsidiary's
country of incorporation. The officers of the parent may
negotiate the drilling contracts and then enter into an
agreement with third parties as officers of the subsidiary.
The parent corporation is not liable on the contracts and
does not guarantee performance of the contracts. The parent
may lease the equipment necessary to conduct the drilling
operations at the safe harbor arms-length charge under the
§ 482 regulations. The day-to-day drilling operations are
managed and performed by on-site employees of the foreign
subsidiary, who are characterized as permanent employees.
The joint officers of the parent and the subsidiary perform
various managerial services for the subsidiary. In many
cases, there will be little or no tax imposed on the service
income by the country in which the services are performed.

Arguably, the parent renders minimal rather than substantial
assistance to the foreign subsidiary, and therefore income
from the drilling operations is not foreign base company
services income. On the other hand, it may be argued that
the income received by the subsidiary is foreign base
company services income because the assistance rendered by
the parent in the form of overall direction of the subsidiary
drilling contracts is substantial. The issue is difficult
to resolve, particularly since important facts may be known
to employees of the foreign subsidiary who cannot be compelled
to testify.

— ' Treas. Reg. § 1 . 954-4 (b ) ( 3 ) example (3).
—' Treas. Reg. § 1. 954-4 (b) ( 3 ) example (3).

83

A construction company will also often use a subsidiary
formed in a tax haven to conduct its construction projects
abroad. A construction project generally will consist of
three phases: (1) a prospectus phase during which the plans
for the project are outlined; (2) a planning phase during
which actual detailed plans will be drafted; and (3) a
construction phase during which a construction manager is
placed on the construction site to supervise the project.

The initial prospectus will often be prepared and
promoted by a U.S. company. If the company is successful in
obtaining the contract, the contract will be signed by
officers of the offshore subsidiary of the U.S. company, who
may also be officers of the U.S. parent. Supervision of the
construction will be conducted by the offshore company
through an on-site manager who is an employee of that company,
but who at one time may have been an employee of the U.S.
parent. He may have obtained all of his knowledge and
skills from the U.S. parent.

As with the drilling rig situation, it may be difficult
to establish that the services were performed for or on
behalf of a related person. Once the company develops
substance overseas, so that fewer of its managerial services
are being performed by the U.S. parent, it becomes more
difficult for the IRS to make the substantial assistance
case.

The Commissioner may be able to allocate some of the
services income from the services to the U.S. parent under
§ 482. The regulations under § 482 provide that where a
member of a controlled group of entities performs managerial
or technical services "for the benefit of, or on behalf of,
another member of the group" without charge, an allocation
may be made -to reflect an arms-length charge for those
services. — ' The test of whether the services were performed
for the benefit of or on behalf of the parent is, as with
the subpart F tests, a very difficult subjective test for
the IRS to apply.

Agents believe that a few of these cases are in fact
abusive. An example of such a situation might be the nego-
tiation and agreement of a construction contract by the U.S.
parent but, at the last minute, having the contract signed

— / Treas. Reg. § 1.482-2(b).

84

by an officer of the tax haven subsidiary. This contract is
valuable and in some cases there has therefore been a transfer
of assets and gain should have been reported or the profits
from the activity should have been reported. Failure by a
sophisticated, well-advised taxpayer to report may be fraud,
but it would be difficult to establish.

Some companies have been able to accumulate significant
income overseas by leasing equipment to a tax haven subsidiary
to be used in the service business. By manipulating the §
482 rental safe harbor rule and the fair market value of the
equipment, significant income can be accumulated in the tax
haven company. This income can be used to create substance
in the tax haven company, which makes the arrangement .between
the two companies even more difficult to challenge.—^

5. Transportation

U.S. companies are engaged in the transportation industry
in tax havens (primarily shipping) to a significant degree.
As of December 31, 1977, 687 foreign flag vessels were owned,
by U.S. companies or foreign affiliates of U.S. companies. — '
Four hundred eighty-eight of these were tankers. Three
hundred eighty-five vessels were registered in Liberia, and
88 were registered in Panama. In 1976, approximately 74
percent of the assets of controlled foreign corporations
engaged in the transportation business were held by companies
formed in tax havens. — ' This represents a substantial
increase over 1968 when 50.6 percent of assets were in
companies formed in tax havens. Most of this use is completely
legal. While there can be significant tax savings, the
structures are within the spirit and letter of the law.

Two aspects of U.S. law encourage the use of tax haven
subsidiaries for carrying on the transportation business:

(1) the reciprocal exemption from U.S. income tax of foreign
flag ships which engage in traffic to and from the U.S.; and

(2) the deferral of tax on the income of foreign corporations
controlled by U.S. shareholders, whether or not they are
engaged in activities involving the U.S. In addition, U.S.
source rules operate to minimize .U.-S. tax even when the
vessels are shipping to the U.S. — '

41/

— See safe harbor rental rule in Treas. Reg. § 1.482-2(c).

42/

U.S. Department of Commerce, Maritime Administration,
Foreign Flag Merchant Ships owned by U.S. Parent Companies ,
April 1979.

43/

—^' See table 2 in Chapter III.

44/

— ' See § 863, and Treas. Reg. § 1.863-4.

85

Earnings derived from the operation of a ship documented
under the laws of a foreign country which grants an equiva-
lent exemption to citizens or corporations of the United
States are exempt from U.S. tax.— ^ To qualify for the
exemption, the foreign country granting the exemption must
be the country of registration of the vessel.—'

Under a provision adopted by the Tax Reduction Act of
1975, syl^part F income includes foreign base company shipping
income; — this is income derived from or in connection with
the use of any vessel in foreign commerce and income derived
from or in connection with the performance of services
directly related to the use of any such vessel or from the
sale, exchange or other disposition of the vessel. Prior to
1975, shipping income was excluded from subpart F. Amounts
reinvested in the shipping business are still excluded.
Amounts of previously excluded shipping income which are
withdrawn from investment in the shipping business are
included as subpart F income in the year of withdrawal.
Accordingly, a company can continue to reinvest its earnings
in the prescribed categories of assets, and not realize
subpart F income.

We have been advised that while it was anticipated that
most companies would be able to qualify for the exclusion
through reinvestment, in fact, because of the glut of oil
tankers, some companies may be forced to report subpart F
shipping income for lack of reinvestment opportunities
within the next few years. Moreover, this provision may be
irrelevant to major petroleum companies because they are in
an excess credit position.

A relatively new development in the petroleum industry
is the transshipment of oil, which originated in 1972 when
the use of super tankers became necessary. The super tankers
load their cargo in the producing countries and transport it
to the Caribbean where the oil is unloaded and stored by a
related corporation, or by an independent transshipping
company. When needed, the oil is loaded on smaller vessels
which bring it to the United States. A terminalling charge
of $.13 to $.17 per barrel has been paid by the refiner to
the transshipper for the removal and storage of the oil.

— / §§ 872(b)(1) and 883(a)(1).

— / Rev. Rul. 75-459, 1975-2 C.B. 289.
47/ § 954(f).

86

However, some transshippers have charged as much as $.30 a
barrel, and the Department of Energy has apparently permitted
$.27 a barrel. In the usual case, the oil will remain in
the terminal for no more than 30 days. The terminalling
company is an offshore tax haven company. Because this is a
relatively new phenomenon, the full extent of use is not
known, but it is generally assumed to be significant. It is
known that most oil imported from the Persian Gulf is transshipped,
One tax benefit can be deferral of the tax on the profit
from the transshipping. If the transshipper is an affiliate,
overcharging can mean a shifting of income from the U.S. to
the tax haven affiliate.

6. Insurance

No deduction is allowed for self insurance. To circumvent
this rule, many companies find it advantageous to form a
wholly owned insurance subsidiary known as a "captive insurance
company" to insure risks of the parent or its affiliates.
If the company is considered an insurance company for tax
purposes, and if it assumes the full risk (does not reinsure),
it can invest the entire premium and realize income most of
which would be free of tax. — '

In the prototype case, the U.S. company forms a Bermuda
company to engage in the insurance business. The captive
must have a minimum paid-in capital of $120,000. The captive
enters into an insurance contract with its parent, pursuant
to which it will insure risks of its U.S. parent or of
foreign subsidiaries of the U.S. parent. In most cases the
captive enters into a reinsurance contract with an unrelated
insurance company. Under this contract, the unrelated
insurance company assumes the risk which had been assumed by
the captive. The captive invests the premium, and then, at
the end of the insurance period, pays over the reinsurance
premium, retaining a small percentage of it. In addition,
it retains the profit realized on the invested premiums.
This investment income is earned because, while the insurance
premiums are paid in advance by the insured, the reinsurance
premiums are not paid by the captive until the end of the
coverage period.

48/

Most captives are formed in a tax haven. Some have
been formed in the United States in Colorado, which
has a captive insurance company law relieving captives
of many of the reserve and other requirements normally
imposed on insurance companies. A Colorado captive
is subject to Federal income tax, but at the favorable
insurance company effective rates.

87

In addition to significant tax advantages, a captive
also provides business advantages. It can underwrite
insurance which is not available in the commercial insurance
market, or i^gavailable only at a high premium or with large
deductibles. — ''^ It can be established in jurisdictions
which free it from many State controls. Bermuda has been
the foremost situs for captives, although the Cayman Islands
is attempting to attract captive business, as are other
havens. — '

The earnings of a captive insurance company are potentially
subject to tax under subpart F, but only to the extent those
earnings are from the insurance of U.S. risks. Subpart F
income^includes income derived from the insurance of U.S. ^^ .
risks, — '^ which includes U.S. property and U.S. residents.—^
If the premiums for insuring U.S. risk do not exceed five
percent of total premium of the foreign company, then the
subpart F provisions do not apply. — ' For purposes of the
subpart F insurance provisions, a foreign corporation is a
controlled foreign corporation if more than 25 percent of
the total combined voting power of all classes of stock of
the corporation is owned directly or indirectly by U.S.
shareholders on any day of the taxable year. — However,
the 25 percent rule, rather than the normal 50 percent rule
for controlled foreign corporations, applies only if the
gross amount of premiums or other consideration in respect
of the reinsurance or the issuing of insurance on U.S. risks
exceeds 75 percent of the gross .amount of all premiums or
other consideration received. — '

Subpart F has not been useful in dealing with captives.
First, there is a U.S. tax advantage to being taxed as an
insurance company, and the subpart F income of the company
would be computed by applying the insurance company rules.
Accordingly, a U.S. company may choose to form a captive
even if its income will be taxed.

49/

— ' See O'Brien and Tung, "Captive Off-Shore Insurance

Companies," 31 N.Y.U. Inst, on Fed. Tax. , 665, 719 (1973).

— See "A Survey of Offshore Captives," Tax Haven and Shelter
Report, 4 (August 1978).

^/ § 952(a)(1).

— / § 953(a)(1).

53/

^^' § 953(a).

— / § 957(b).

ii/ Id.

88

Second, the insurance company rules are considerably
narrower than the foreign base company income provisions,
and therefore apply in fewer cases. The provision is
limited to income from insuring U.S. risks. — ' The foreign \

risks of affiliates, therefore, may be insured without
generating subpart F income. The foreign personal holding
company rules generallyj-do not apply to the passive income
of the foreign insurer, — ' and certain amounts relating to
reserves for foreign risks can be invested in U.S. property
without being taxed to the U. S. ^.shareholders as an increase
in investment in U.S. property. — ' Arguably, however, insuring
the foreign risks of affiliates will generate foreign base
company services income.

The IRS has sought to deal with captives outside of
subpart F. It has ruled that a premium paid by a domestic
corporation and its affiliates to a captive insurance company,
either directly or through an intermediary independent
insurance company which reinsures with the parent's captive,
is not deductible because there is no economic shifting or
distribution of risk of loss with respect to any of the risk
carried or retained by the wholly owned foreign subsidiary.
To the extent that an unrelated insurer retains the risk, or
to the extent that the risk is shifted to an unceLated
insurance company, the premiums are deductible. — ' IRS has
also ruled that the so-called "insurance premiums" paid by
domestic subsidiaries of a U.S. parent were to be considered
distributions of dividends to the parent, and then as a
contribution to capital of the foreign subsidiary by the
parent. Also, the ruling held that the companies were not
insurance companies for tax purposes. This view was upheld
by the Tax Court in Carnation Company v. Commissioner. — '

(

56/

§ 953(a)

— / § 954(c)(3)(B); see § 954(c)(3)(C), which excludes from
subpart F investment yields on an amount equal to one-
third of the premiums earned on certain insurance contracts,
provided they are not attributable to risks of related

persons,
i^/ § 956(b) (2) (E).

59/
60/

Rev. Rul. 77-316, 1977-2 C.B. 53.

71 T.C. 400 (1978), appeals pending (9th Cir. 1978).

89

Under the IRS view, therefore, the deduction of premiums
paid to a captive would be denied, and, in the case of
premium payments for insurance by foreign subsidiaries to
the captive, there would be a constructive dividend to the
parent which would be taxable income, followed by a contribution
to the capital of the foreign captive. The foreign captive
would not have subpart F income because it would not be
engaged in the insurance business. Because the amounts are
contributions to capital rather than premium income, the
foreign corporation does not have any gross income from the
purported insurance transactions, hence it does not have any
foreign source income for purposes of the foreign tax credit
limitation. — '

The IRS has ruled, however, that where the company is
not a wholly owned captive, but rather is owned by a group
of taxpayers, premiums will be deductible. — '

Despite IRS attention to this area, the data show that
significant captive insurance business continues. In some
cases the captive insurance companies are beginning to
write small amounts of insurance for unrelated third parties.
In one case a captive has reached the point where 70 percent
of the risk insured by it is risk of unrelated parties. By
insuring some unrelated risk, it is intended that the company
will be deemed an insurer and the premium paid by the domestic
parent will be deductible. Because income from insurance of
foreign (even if related) risk is not subpart F income, it
can be expected that captives will continue to grow if
taxpayers can avoid the holding of Carnation . Captives have
also begun to underwrite open market business by participating
in "pools" in order tp-improve their chances of being considered
an insurance company. — ' Because the premiums from the related
and unrelated income are not fragmented for tax purposes, sub-
stantial amounts of income arguably can be shifted to a captive
if it writes some unrelated risk.

— See Carnation Company , Id.

62/

63/

Rev. Rul. 78-338, 1978-2 C.B. 107, holding that a foreign
insurance company owned and organized by 31 domestic
companies was a viable insurance company.

"A Survey of Offshore DDcation for Captives", Tax Haven
and Shelter Report, 4 (August, 1978).

90

Another method of attempting to circumvent the Carnation
case, and the IRS position, is the use of a so-called "rent-
a-captive". Under this scheme, the taxpayer enters into an
insurance contract with an unrelated U.S. commercial insurer
that in turn enters into a reinsurance agreement with a
tax haven company and cedes most of the premium to it.
Payments of the reinsurance premiums are made at the time
the taxpayer pays the premium so that the cash balances are
held by the tax haven company. The taxpayer then purchases
nonvoting preferred stock in the tax haven company. The
shares have a value equal to a fixed percentage of the
premium of the primary policy. After a period of years, the
taxpayer gets a return of the capital paid for the preferred
shares plus investment income on the capital and loss reserves.
The taxpayer can borrow an amount equal to its capital and
pay interest to its preferred account.

The promoters take the position that the premiums are
deductible, and that the income of the tax haven company
will accumulate free of tax, because the company's share
dispersal will be such that it will not be a controlled
foreign corporation. In addition, they claim that there
will be adequate risk shifting if properly structured so
that the premiums will be deductible. Finally, they point
out that large multinational corporations can benefit because
the income realized when the preferred shares are redeemed
will be considered foreign source income which will increase
allowable foreign tax credits.

7. Banking

united States banks continue to conduct significant
business through offshore financial centers. Generally, the
business is conducted in branch form and the income generated
is taxed currently by the U.S., subject to the availability
of the foreign tax credit as limited by the overall foreign
tax credit limitation. In some cases, however, U.S. banks
establish holding companies and other subsidiary corporations
in the havens to conduct trust or other businesses. A few
of the large U.S. banks have a presence in most, if not all,
of the tax havens.

The use of tax havens by banks is large and growing.
Many major banks now have trust companies in the havens.
These companies are not subject to U.S. tax under subpart F.
Wholly owned subsidiaries of U.S. banks in the Bahamas,
Cayman Islands, Netherlands Antilles, Panama, Hong Kong,
Luxembourg, Singapore, and Switzerland had combined surplus
and undivided profits of over $500 million at the end of
1979. The total earnings of subsidiaries of large banks in
these tax havens were $96 million in 1976.

91

D. Transactions Through An Entity VThich Is Not Controlled

The anti-avoidance provisions which apply to foreign
transactions generally require that the foreign entity being
scrutinized be controlled by a U.S. person. Without control,
many of the reports by which transactions with potential
U.S. tax consequences are identified arguably do not have to
be filed, and the powers to compel production of records are
unclear.

The subpart F or foreign personal holding company
provisions apply to a foreign entity only if that entity is
controlled by U.S. persons. Income is attributed to U.S.
persons under subpart F only if-the foreign corporation is a
controlled foreign corporation. — A foreign corporation is
a controlled foreign corporation if more than 50 percent of
the total combined voting power of all classes of its voting ,^.
stock is owned, or is considered as owned, by U.S. shareholders. — '
A U.S. shareholder is a U.S. person who owns 10 percent or
more of the voting stock of the foreign corporation. — '
There is no equity or value test for purposes of determining
whether or not a corporation is a controlled foreign corporation.

The regulations make clear that arrangements to shift
nominal voting power to non-U. S. shareholders, when actual
control is retained, will be disregarded. — ' The IRS has
successfully defended this regulation in court. All of the
litigated cases involved domestic corporations attempting to
"decontrol" their foreign subsidiaries through the issuance
of voting preferred stock to non-U. S. shareholders. — '

Nevertheless, if real decontrol can be achieved, subpart
F does not apply. A foreign corporation can be structured
so that U.S. persons own one-half or less of its voting
stock, but more than one half of the equity in the corporation

64/

§ 951(a) .

^/ § 957(a).

6^/
67/
68/

§ 951(b) .

Treas. Reg. § 1.957-1.

Garlock, Inc. v. Commissioner , 489 F. 2d 197 (2d Cir.
1973), cert, denied , 417 U.S. 911 (1974); Kraus v.
Commissioner , 490 F. 2d 598 (2d Cir. 1974), aff 'g . 59
T.C. 681 (1973); Koehring Co. v. United States , 583 F.
2d 313 (7th Cir. 1978). But see , CCA Inc. v. Commissioner ,
64 T.C. 137 (1974), acq. 1976-2 C.B. 1.

92

through, for example, the use of voting preferred stock.
Because there is no value test, the corporation (assuming
that actual control cannot be proved) is not a controlled
foreign corporation.

Moreover , a
as owning 10 per
power of the for
corporation may
shareholders, ea
stock, and it wi
subject to tax u
a foreign person
test under those
individual share
a foreign corpor

U.S. share
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be formed w
ch owning n
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nder subpar
al holding

provis ions
holders of
ation's out

holder must own or
e of the total comb
ation. Accordingly
ith its stock owned
ine percent of the

controlled foreign
t F. In addition,
company because the

is ownership by fi
more than 50 percen
standing stock.

be considered
ined voting
, a foreign

by 11 U.S.
corporation ' s

corporation
it will not be

ownership
ve or fewer
t in value of

Methods have developed for maintaining actual voting
control, while achieving technical decontrol for subpart F
purposes. One such method is the issuance of "stapled",
"paired", or "back-to-back" stock. A domestic parent corporation
forms a tax haven subsidiary and then distributes ratably to
its shareholders its stock of the foreign subsidiary. The
shares of the two companies are tied together so that they
can be transferred only as a unit. The IRS has ruled, in
the domestic context, that the result is a brother/ sister
relationship between the two corporations, rather than a
parent/subsidiary relationship, and that the distribution of
the subsidiary's stock is a distribution of property includable
in income as a dividend distribution to the parent shareholders.
The result of the published IRS positions is that controlled
foreign corporation status is avoided.

The distribution may be treated as a dividend to the
shareholders of the U.S. company. If, however, the sub-
sidiary is not valuable at the time its stock is distributed,
decontrol may be achieved at little cost. In addition, the
distribution may qualify as a tax free reorganization.

In one case a U.S. company spun off to its shareholders
the stock of its wholly owned tax haven subsidiary. Within
a few years, the gross income of the tax haven company grew
to well over $100 million.

69/

69/

Rev. Rul. 54-140, 1954-1 C.B. 116. See also Rev. Rul .
80-213, 1980-28 I.R.B. 7. Stapled stock may also be
used to avoid the boycott provisions of § 999 of the
Code, and with a DISC to avoid taxation of DISC income
at the corporate parent level.

93

Another method for attempting to avoid the subpart F
provisions is to do business through a controlled foreign
corporation which is a partner in a foreign partnership.
The foreign base company sales income and the foreign base
company services income rules apply to transactions with
related persons. The term related person does not include a .
partnership controlled by a controlled foreign corporation.— ^
Accordingly, a U.S. person could arguably form a controlled
foreign corporation which in turn would enter into a partnership
with ^n unrelated person and enter into base company type
transactions through the partnership. Even if the other
person had a relatively small interest in the partnership
(for example, 10 percent), the related party status, and
thus subpart F, would be avoided. — '

Promoters have sold decontrol through fraudulent schemes
which attempt to avoid all reporting requirements and thus
IRS scrutiny. For example, the May 1980 issue of the Journal
of T axation describes a scheme in which a Panamanian corporation
establishes a British Virgin Islands (BVI) trust for the
benefit of the Mexican Red Cross, contributing to the trust
a nominal sum of money. The trust then organizes a Hong
Kong company. Ninety-six percent of the stock is issued to
the trust and four percent is issued to the U.S. person who is
the investor. The BVI trust then has the U.S. person assume
management and control over the Hong Kong company.

The promoters apparently take the position that the
Hong Kong company is neither a controlled foreign corporation
nor a foreign personal holding company, because control is
in the BVI trust which is a foreign trust created by a
foreign grantor and having a foreign beneficiary (the Mexican
Red Cross). Further, the promoters take the position that
the U.S. investor does not have to file a Form 959 because
the U.S. person acquired less than five percent of the stock
of the foreign corporation. Under this theory, no other
return would have to be filed. The Mexican Red Cross never
gets anything because the company never pays dividends.
Instead, its profits are "lent" to the U.S. investor.

70/

See § 954(d) (3).

— / See MCA Inc. v. United States , 46 AFTR 2d 80-5337 (D. C.
CD. Cal. 1980), holding that a partnership consisting
of a controlled foreign corporation and an employee
trust was a corporation related to the controlled foreign
corporation. Lack of separate interests among the
partners caused the alleged partnerships to be treated
as corporations. See Toan, "Foreign Base Company
Services Income," Subpart F - Foreign Subsidiaries and
Their Tax Consequences , Feinschreiber , ed. , 132 (1979).

94

In another scheme, the 50 percent threshhold has been
combined with improper transfer pricing in a fraudulent
scheme to syphon patent royalties into a tax haven holding
company. For example, U.S. company X wants to license a
patent from unrelated foreign licensor Y. It is anticipated
that the royalties will be $100 per year. X's after tax
cost would be $54 ($100 less $46 tax). Instead, X and Y
form tax haven corporation Z in a treaty country. Y licenses
the patent to Z which sublicenses to X for $200 per year. X
deducts the $200. While X's cost is $200, its after tax
cost is $8 ($200 less $92 less $100 in the tax haven corporation)
Further, the $100 X owns in the tax haven corporation can
earn investment income free of U.S. and local tax. X will
not have subpart F income because it does not own more than
50 percent of the stock of Z. The scheme is fraudulent, but
cloaked in legitimacy. The participation of the unrelated
licensor may make it difficult for the IRS to establish
improper transfer pricing.

The application of the §482 rules may also be avoided
through decontrol. In order for §482 to be applied, the
organizations dealing with one another must be owned or
controlled, directly or indirectly, by the same interests.
The regulations define the relationship broadly, stating
that "the term control includes any kind of de facto control,
direct or indirect, whether leqally enforceable, and however
exercisable or exercised...." — ' Nevertheless, control
still must be found in order for a § 482 allocation to be
possible. Therefore, in cases where decontrol is achieved,
arguably not only do subpart F and the foreign personal
holding company provisions no longer apply, but allocations
can no longer be made under § 482.

E. Principal Patterns of Abusive Tax Haven Use Predominently
by Promoters and by Individual Taxpayers

Individuals use tax havens in many of the same ways and
for many of the same reasons as do multi-national companies.
Thus, many of the structures described above are used by
individuals. Promoters, including tax practitioners, have
also been advising individuals to use tax havens to abuse
the tax structure. Some of these uses are highlighted
below.

1. Background

The earliest anti-avoidance legislation, the predecessors
of §§ 367, 1491 and the foreign personal holding company and
personal holding company provisions, were intended to deal
with abusive tax avoidance by individuals. In a letter to

72/

— ' Treas. Reg. § 1. 482-1 ( a ) ( 3 ) .

95

President Roosevelt, Secretary of the Treasury Morgenthau
cited numerous instances of the abusive use by individuals
of holding companies in the Bahamas, Panama, and Canada
(then a haven). The uses included creation of artificial
deductions by means of loans made to individuals by their
personal holding company, removing assets (three million
dollars in one case) to a Bahamian company, with the individual
shareholder then filing returns in successive years from
such diverse places as New Brunswick, Maine, British Columbia,
Jamaica, and expatriation by a retired army officer who
immediately established Bahamian corporations to hold and
sell his securities. — '

Many of the most flagrant abuses of holding companies
seem to have been curtailed. Significant use of tax havens
by individuals, however, is still possible and much of it
does not comport with Congressional intent. There appears
to be a growing use of tax havens for small transactions.

2. Patterns of Use

Described below are some of the abusive schemes we have
seen by which individuals have attempted to use tax havens
to avoid U.S. tax.

a. Investment Companies

A promoter forms P, a Bermuda company, which in turn
forms a Bermuda subsidiary (S) to engage in speculative
trading in commodity futures and forward contracts. All of
the stock of P is held by U.S. persons. All trading is to
be done by S. S receives a ruling from Bermuda authorities
that it is exempt from current and future Bermuda taxes.
The promoter takes the position that neither P nor S will
incur U.S. tax because: they are foreign corporations; will
not conduct business in the U.S.; will not have any U.S.
source income; P's share dispersal among U.S. persons will
be such as to avoid controlled foreign corporation or foreign
personal holding company status; and capital gain on the
disposition of P's shares will be afforded by avoiding
§ 1246, because the company did not register under the
Investment Company Act of 1940 and was not engaged in trading
or dealing in securities.

73 /

-^' See report of the Joint Committee on Tax Evasion and

Avoidance of the Congress of the United States, 75th

Cong., 1st Sess., No. 337 (1937) at 1.

96

The Congress adopted §1246 in 1962 in an effort to
limit what it considered an abuse which had arisen by persons
forming investment companies in tax havens with shares being
sold to U.S. persons. Prior to 1962, the company was not
taxed, and the U.S. shareholders were taxed at the favorable
capital gain rates when the shares were sold or redeemed.
Section 1246, however, applies only to a company which
trades in securities. Arguably, commodities futures contracts
are not securities, and thus §1246 does not apply. In
addition, the company would not^be a personal holding company
because of its share dispersal. — ' In any event, personal
holding company- income does not include income from trading
in commodities. — ' Furthermore, if the commodity transactions
are executed in the U.S. through a U.S. broker, S will not
be engaged in trade or business in the U.S. and the short-
term capital gain realized on the sales will not be taxed in
the U.S. because it is not fixed or determinable income.

S might be subject to the accumulated earnings tax on
its U.S. source income if its earnings are accumulated
beyond the reasonable needs of the business. In an attempt
to avoid this result, S will distribute dividends to P. P
will not be subject to the accumulated earnings tax because
it does not have U.S. source income. However, § 269 might
apply to enable the IRS to disregard S, in which case P
would have to distribute the income to its U.S. shareholders
or pay the accumulated earnings tax.

b. Trading Company

A promoter forms a company in the Grand Cayman Islands,
citing the company's tax-free status there. The promoter
purchases 50 percent of the shares in the company, and the
other 50 percent are sold to 20 unrelated U.S. individuals.
Each person who purchases shares signs a contract obligating
himself to pay up to $10,000 over a period of 18 months.
The agreement provides that the profits will be split fifty-
fifty between the shareholders and the corporation during
the 18-month period. Afterwards, all of the profits will
belong to the corporation, with the shareholders receiving
distributions. The promoters take the position that there
is no U.S. tax because the company is not a controlled

— / § 542(a)(2).
— / See § 543.

97

foreign corporation or a foreign personal holding company,
because it does not meet the "more than" fifty percent
ownership test. The promoters also take the position that
the $10,000 payment is a deductible reimbursement for expenses,
and not an investment in assets.

c. Holding Companies

Foreign companies have been used in an attempt to shelter
royalty or similar income. In one case a U.S. person purchased
the movie rights to a series of books. A Swiss corporation
was formed, with a U.S. individual receiving 50 percent of
the stock and a U.S. distributor receiving 50 percent of the
stock. The individual transferred the movie rights to the
Swiss corporation. The Swiss corporation then gave the
distribution rights to the film to the U.S. distributor.
Royalties are paid to the Swiss company, which claims that
activities of the corporation are conducted by the Swiss
company in Switzerland. Under the U.S. -Swiss treaty, the
royalties are exempt from tax by the U.S. The company has
accumulated millions of dollars and has paid only limited
dividends. The U.S. individual shareholder has borrowed
millions from the company, and has paid only interest. Most
of the company's retained earnings are invested in the U.S.
in CD's, or are invested in the Eurobond market. The company
claims that it is engaged in an active business and that
it does not have subpart F income. In fact the shareholders
should be taxed on the loans to them under § 956.

d. Shelters

Abusive tax shelters present the IRS with one of its
most serious compliance problems. The IRS has identified
approximately 25,000 different shelter promotions in recent
years. These involve roughly 190,000 returns and perhaps as
much as five billion dollars in potential adjustments.

A recent, and apparently growing, phenomenon is the
interjection of an offshore jurisdiction into the shelter
scheme. A tax haven may be used in an attempt to hide the
fact that a transaction upon which a deduction is based
never took place, to hide the promoter's profit, or to hide
the list of investors. Also, losses may be transferred to
an investor's account in a tax haven and the ownership
relationship with the account hidden. Tax haven shelter
activity appears to have increased markedly over the past
few years; and, in a few cases, previously domestic shelter
schemes have moved off-shore in later years.

98

(i) Commodities . We have identified a number of cases
where offshore entities or locations were used to faciliate
alleged commodity transactions. Generally, these are so
called "tax spreads" which seek to give the investor a tax
advantage by generating large ordinary losses in year one,
and then long-term capital gain in year two. The benefit to
the taxpayer is the difference between the tax saved on the
ordinary loss and the tax paid on the capital gain. A
Treasury Bill-GNMA straddle is entered into to produce
ordinary loss on the T-Bill leg and long term capital gain
on the GNMA leg. The purpose is to convert ordinary income
in one year into long term capital gain in the immediately
succeeding year. The taxpayer liquidates his loss by
covering the short sale on the T-Bill leg. The taxpayer
then borrows money to cover the loss from a broker located
in the Bahamas, and locks in the gain by entering into a
contract to deliver the GNMA's at the current price in
twelve months. At the end of the twelve month period, the
taxpayer delivers the GNMA's and realizes long terra capital
gain. There is evidence that the transactions may never
have taken place. In one case, a revenue agent estimates
that there may be as many as 1,500 investors and deductions
of as much as $150 million.

Another scheme has been marketed over a four year
period to at least 500 taxpayers. The IRS has identified
40 income tax returns for two taxable years which were
involved with this tax shelter on which losses were deducted
in excess of $4,000,000.

Salesmen for the taxpayer will approach wealthy individuals
and advise them that they have a perfectly legitimate tax
shelter device which will allow the investor to double his
money in one year. It is explained that the marketing
organization will set up for the taxpayer a foreign trust
which will be located in a tax haven jurisdiction. The
foreign trust will be a grantor trust which will have the
taxpayer as its sole beneficiary. The trust will be formed
ostensibly for the purpose of investing in gold and silver
with the idea of making a profit.

The investor puts up $20,000 in cash which constitutes
the corpus of the trust. The trust subsequently becomes a
limited partner in a limited partnership formed in Liechtenstein
or another tax haven. The limited partnership is a foreign
partnership not doing business in the United States which
would not be subject to United States income tax. The
stated business of the partnership is investing in gold or
silver with the intent of making a profit.

99

Next, three simultaneous contracts are entered into.
In the first contract, the partnership borrows from a foreign
bank $1,200,000 payable one year from the date of the loan
with interest at the rate of 10% per annum, so that the
interest during the first year would be $120,000. The
general partner is supposed to pay the interest. The trust
as a limited partner would enter into an agreement stating
that the trust would be responsible for the payment of the
interest in the event of default. Next, the partnership
purchases gold or silver valued at $1,200,000 which is
pledged as collateral for the $1,200,000 bank loan. Finally,
the partnership enters into a contract to sell the gold or
silver one year from the date of the contract at a profit
of 10% or $1,320,000.

The taxpayer is advised that as a result of these
transactions during the first year the partnership pays
interest in the amount of $120,000, has no income, and thus
has a loss in the amount of $120,000 which would flow through
the trust to the individual investor. Assuming the taxpayer
is in the 50 percent tax bracket, the $120,000 deduction
would be worth $60,000 in tax savings to the taxpayer.
Thus, for an investment of $20,000, the taxpayer has recouped
his initial $20,000 plus he has received a profit of $40,000
payable by the United States Government. He has thus managed
to double his money with no risk.

During the second taxable year, the trust should have
capital gain of $120,000 with no offsetting deductions.
Thus, the ordinary loss has been converted into capital
gain. However, the taxpayer may enter into a similar arrangement
during the second taxable year. The trust will have neither
gain nor loss because the $120,000 gain resulting from the
first series of transactions will be offset by an interest
deduction of $120,000 resulting from the second set of
transactions. Thus, by entering into similar arrangements
each year on the anniversary date of the contracts, the
taxpayer may postpone indefinitely the recognition of gain.

In point of fact, none of these transactions takes
place, although the taxpayer-investor is lead to believe
this is a legitimate tax shelter which can be used to offset
income taxes.

In reality, the promoter of this tax shelter utilizes
the services of foreign attorneys, accountants, nominee
corporations and foreign banks for the purposes of creating
documentation of transactions which are not consummated.
Thus, the investor will be furnished with letters and a
contract from foreign attorneys which purportedly establish

100

the validity of the gold or silver transaction as well as

the bank loans and interest payments. These documents will

then be provided to the IRS upon audit to substantiate the
taxpayer's claimed deductions.

The promoter uses the services of a nominee tax haven
corporation which receives the investor's original $20,000
investment. This money is deposited in a bank located in a
tax haven jurisdiction in an account under the name of the
nominee corporation. Subsequently, the taxpayer arranges
through the use of a United States corporation to "borrow"
money from the bank in which has been deposited the investor's
original $20,000. The promoter, in turn, borrows this money
which he uses for personal living expenses.

A similar straddle was arranged through a domestic
trust. In order to avoid partnership reporting, a domestic
trust was formed for the benefit of the investor. The domestic
trust then becomes a beneficiary of a Bahamian trust. The
Bahamian trust realizes the brokerage losses, which are
distributed back to the domestic trust and in turn to the
U.S. taxpayers.

Offshore commodity schemes to defraud the consumer
rather than the IRS have also been marketed. Commodity
brokers may establish accounts in a tax haven and structure
commodity trading losses through those accounts. The broker
will deny ownership of the accounts. In some cases, such an
account has been used to defraud the investor. For example,
a Cayman company sells silver options to investors. If the
investor decides to exercise the option, he is told that the
silver has been lost or that the company is insolvent. The
investor has lost his investment.

Both the Securities and Exchange Commission and the
Commodities Futures Trading Corporation are investigating
offshore commodity schemes.

(ii) Movies . A U.S. promoter forms a corporation in
Liechtenstein which purchases a low grade movie. The movie
is then sold to a U.S. partnership for up to fifty times
the purchase price. The consideration paid by the partnership
might be 10 or 15 percent of the inflated sales price in
cash and a nonrecourse note for the remainder. The cash
remains in the Liechtenstein corporation and the note is
never paid. The investors receive a statement from the
promoter showing the payment of interest and other fees for
a particular year, and take deductions accordingly.

101

(iii) Foreign situs property . A number of cases have
been identified in which the property which is the shelter
investment is located in a foreign country which may or may
not be a tax haven. Even where the property is not in a
tax haven, the investment vehicle (partnership or trust) or
the promoter may have a tax haven address. One case involved
the sale of an interest in a South African mine. Each
investor paid a 20 percent "advanced" royalty in cash and
signed a non-recourse note guaranteed by a Cayman insurance
company for the balance. The investors deduct the start-up
costs, and the promoting entity (which it is alleged is
owned by U.S. persons) retains the advanced payment. Revenue
agents involved estimated that they had identified $30
million in deductions through this shelter, and that investors
may have taken as much as $150 million in deductions.

Other cases involving South and Central American gold
mines were identified. The shelter vehicles had in fact
purchased mining claims but their valuations were too high.
In the case of one promotion, we have identified a number of
returns with deductions for "mining development costs" of as
much as $175,000. It would be difficult for the IRS to
refute the valuation, if that were necessary, because of the
lack of availability of expert witnesses.

e. Foreign Trusts

Foreign trusts have been an important vehicle for tax-
free investment by U.S. persons, in or through tax havens.
Prior to 1962 a trust afforded the deferral advantages of a
foreign corporation, and in addition could accumulate passive
income without foreign personal holding company consequences.
In 1962, Congress subjected beneficiaries of foreign trusts
created by U.S. persons to an unlimited throv/-back rule at
the time of the ultimate distribution of accumulated income.
The distributed income itself was taxed whether it represented
gross income from sources within or without the United
States. Unless distributed, however, the income could be
accumulated tax free in a tax haven.

In 1976, Congress dealt more directly with foreign
trusts by removing the deferral privilege for foreign trusts
created by a U.S. person if the foreign trust had or acquired
United States beneficiaries. Today, a U.S. person who
directly or indirectly transfers property to a foreign trust
is treated as the owner for the taxable year of the portion
of the trust attributable to the property transferred, if
for the year, there is a U.S. beneficiary of any portion of
the trust.— '^ The provisions apply to both direct and

— / § 679(a)(1).

102

indirect transfers, and include transfers by gift, sale,
exchange or otherwise. An exception is provided for transfers
by reason of the death of the transferor. In addition, an
exception is provided for any sale or exchange of property
at its fair market value in a transaction in which all of
the gain to the transferor is realized at the time of the
transfer and is recognized either at that time or is returned
as is provided in § 453.

Generally, a trust has a U.S. beneficiary unless the
trust instrument provides that no part of the income or corpus
may be paid or accumulated for the benefit of the U.S.
person. Attribution rules are provided under which a foreign
corporation is treated as a U.S. beneficiary if more than 50
percent of the total combined voting power of all classes of
stock is owned, or is considered owned, by U.S. shareholders
under § 958. A foreign partnership is treated as a U.S.
beneficiary if any U.S. person is a partner of the partnership
directly or indirectly. A foreign trust or estate is considered
a U.S. beneficiary if the foreign trust or estate has a U.S.
beneficiary.

The Tax Reform Act of 1976, while significantly curtailing
the ability of U.S. persons to use foreign trusts, did not
eliminate them. Some practitioners believe that foreign
trusts may still be used to a U.S. tax advantage, either by
structuring transactions to avoid § 679 or by the using
rules of § 679 to achieve certain tax advantages. Most are
abusive, and in any event distributions of property from a
foreign trust would incur the onerous interest charge on
accumulation distributions imposed by §668.

A foreign trust may be used to avoid the corporate
anti-abuse provisions in some cases. For example, if a
foreign trust is not a § 679 trust, then a sale by the trust
of stock of a controlled foreign corporation will not be
subject to the ordinary income rules of § 1248, because
§ 1248 applies to a U.S. person who sells or exchanges stock
in a foreign corporation. Likewise, gain on the sale of
collapsible corporation stock (which should be taxable as
ordinary income) would be deferred until the proceeds are
distributed to the beneficiaries. Some claim that the stock
can be transferred to the trust by a long-term installment
sale thus qualifying for the sale or exchange exception.

103

Section 679 does not apply to any transfer by reason of
the death of the transferor, nor does it apply to an inter
vivos trust after the death of the transferor. Therefore, a
foreign trust can still be used as an estate planning tool.
Distributions would, however, be taxed to the beneficiaries,
and the interest charge imposed by § 668 would apply to
those distributions. In the alternative, an inter vivos
trust can be created, and property transferred to it. A
U.S. grantor can transfer non-income producing property with
appreciation potential to the trust. The transferor is
subject to tax on the income from the property but, because
the property is non-income producing he will pay no tax.
Further, if the property generates losses, the grantor will
receive the benefit of those losses during his lifetime.
After his death, the property can be sold and the assets
invested in income producing property, with the income
accumulating for the benefit of the beneficiary. While
distribution will incur tax and an interest charge, some
beneficiaries attempt to take the income out in the form of
"loans" which are not taxed unless they are detected.

Section 679 does not apply to a sale or exchange of
property at its fair market value in a transaction in which
all of the gain to the transferor is realized at the time of
the transfer and is recognized either at such time or is
returned as provided in § 453. Accordingly, a U.S. person
can purchase property, wait for it to appreciate slightly
(to qualify for the "gain realized exception"), and then
sell it to a tax haven trust which he created. He will
realize gain but take back a long-term installment note at
stated interest, thereby according current reporting of that
gain.

Some practitioners seem to be taking the position that
§ 679 is avoided if a ,§ 1057 election is made for a transfer
to a foreign trust. — ' A combination of these exception
provisions might then be used in conjunction with a foreign
trust to accelerate the recognition of gain without disposing
of property, by transferring appreciated inventory to a
foreign trust, making a § 1057 election (thereby recog-
nizing gain), and then, when the inventory is needed back,
liquidating the trust. The gain could be used to offset
expiring net operating loss carryovers. The inventory would
come back at a stepped-up basis, so that sales of the inven-
tory would not generate income (unless the inventory had
further appreciated).

— / § 679(a)(2)(B)

104

A foreign trust can be used to generate losses for the
benefit of the grantor (this can also be done with a domestic
trust). One scheme which has been described is for a U.S.
grantor to transfer property to a foreign trust for the
benefit of foreign beneficiaries. In the years when there
are significant losses, a beneficiary can establish residence
in the U.S., thereby flowing the losses through to a U.S.
resident. If it appears that the trust will earn income for
a year, the beneficiary can return to his own country. It
is unlikely that such a scheme really happens often.

Section 679 applies only to transfers by U.S. persons.
A nonresident alien emigrating to the U.S. may, prior to
assuming resident status, make a transfer to a foreign trust
with a U.S. beneficiary, and not be subject to § 679 when he
becomes a U.S. resident. Similarly, a nonresident alien
individual spouse who intends to make a § 6013 (g) or (h)
election to be treated as a U.S. resident could make the
transfer in a„year before the first year to which the election
is to apply. — ' If a foreign trust does not have U.S.
beneficiaries in the year of a transfer by a foreign person,
and if the foreign beneficiaries become U.S. beneficiaries
at the same time the transferor becomes a U.S. person,
neither § 679 (a) (1) nor § 679 (b) (concerning trusts
acquiring U.S. beneficiaries) applies. Consequently, the
§ 679 rules are avoided and income can be accumulated abroad
free of tax for the benefit of a person who is not a U.S.
resident. However, any distribution will incur the §668
interest charge.

f . Double Trusts

A number of persons have been promoting a fraudulent
scheme known as so-called "double trusts" or "triple trusts"
as a method for avoiding U.S. income taxation. Over 200
returns which appear to involve these trusts have been
identified.

Under one such scheme the taxpayer agrees with a promoter
to enter into a "double trust" arrangement. After payment
of a large fee to the promoter, the promoter arranges for a
foreign person to create a trust in a tax haven. The foreign
creator appoints the taxpayer as trustee and the taxpayer
transfers assets to the trust. The assets may range from
real estate to an active business. The foreign person then
creates a second trust in the same tax haven and names the

78/

— ^ Sections 6013(g) and (h) permit certain nonresident

alien individuals married to U.S. citizens or residents

to make an election to be treated as U.S. residents.

105

first trust as trustee of the second trust. The beneficiary
of the second trust may be a friendly foreign "Credit Union".
The trustee is given broad powers to deal with trust property.

The first trust will earn the income and the trustee
will distribute it to the second trust. The second trust
will, from time to time, make distributions in the form of
gifts or loans to the taxpayer or his family. If the assets
of the first trust include an active business in the U.S.,
the trusts should, and many of them do, file an income tax
return. Many of these returns eliminate taxable income by
reporting the payment of a "contingent royalty", presumably
to the second trust. Some of the returns identified indicate
that the offshore entity is purchasing supplies and selling
them to the Uhited States party at an inflated price. The
profit is being accumulated in the tax haven, or is being
returned to the taxpayer as a gift or a loan.

Section 679 will apply to these trusts if the U.S.
person (or any U.S. person) is a beneficiary. The indirect
transfer rule may apply to the second trust if the "expenditures"
are fraudulent, as may be the case. In the case of the
transfer of business assets, §679 clearly applies. The
ultimate beneficial interest, which may be shown by the
receipt of a "gift" or "loan", is owned by a U.S. person.
If U.S. persons are not the ultimate beneficiaries, then § ^g,
679 does not apply, but § 1491 should apply to the transfer. — ^

The double trust problem is a compliance problem — proof
of the existence of the foreign trusts, the U.S. beneficiaries,
the fraudulent nature of deductions, etc. , must be obtained.
Once obtained, § 679, 1491, or the grantor trust rules
should apply. Identification of returns (if any) involving
double trusts is an important step.

g. Generating Deductions

Tax haven entities have been used to generate
deductions other than shelter deductions. An example of a
scheme is contained in an article about recent IRS successes
in the Tax Court. The cases involved transactions planned
by Harry Margolis, a west coast attorney. According to the
Wall Street Journal, an investor would arrange to "borrow"
$50,000 from an entity called Anglo Dutch Capital Co., which
the government alleged existed only on paper. Then the
investor would invest the loan proceeds in Del Ceiro Associates,
another entity the article alleges was controlled by Mr. Margolis.
With $5,000 in real cash, the taxpayer would prepay a year's

— / See Rev. Rul 80-74, 1980-1 C.B. 137.

106

interest on the loan he supposedly got from Anglo Dutch.
But, according to the Journal, the "investment" in Del Ceiro
would turn sour, and the client would take a total deduction
of $55,000 for his loss plus the interest he paid on his
loan. The Tax Court has found this case and others like it
to be shams.

There are over 800 additional cases docketed against
clients of Mr. Margolis. If each case had to be tried
separately, it would take years to resolve them.

h. Expatriation

U.S. persons can leave the U.S. and renounce their
citizenship in order to avoid paying U.S. taxes. For example,
if a U.S. person owns appreciated property, he may move to a
low tax haven such as the British Virgin Islands or Bermuda,
establish residence and renounce his U.S. citizenship, and
then obtain a British passport which enables him to move
around the world. In some cases, the U.S. person may even
expatriate to a country such as Canada, which gives an
immigrant a basis in his assets equal to their fair market
value as of the date residence is established.

United States tax law limits the advantage of expatriation
for tax purposes, by retaining .jurisdiction to tax the
expatriate in limited cases. — ^ Under the Code, the expatriate
would be taxed on his U.S. source income and his foreign
source effectively connected income. For purposes of this
provision, income from U.S. real estate, stock or securities
of a U.S. corporation, and debt of a U.S. person, would be
considered U.S. source income taxable to the expatriate.
This provision applies only to income earned within ten
years of the date of expatriation. No tax is imposed on
foreign source income, including income from the disposition
of appreciated foreign assets.

In addition to permitting expatriation to avoid U.S.
tax on foreign assets, the U.S. law is difficult to administer.
Once the U.S. person has removed himself from U.S. jurisdiction,
various schemes can be used to dispose of U.S. assets in a
manner which makes it difficult to detect.

In one case a U.S. person, allegedly to avoid U.S.
capital gains tax on over $20 million in appreciation,
expatriated and almost immediately sold his appreciated
stock in a foreign corporation.

10/ § 877.

107

F. Use by Foreign Persons Doing Business in or Residing
in the U.S.

Foreign persons investing in the U.S. or doing business
in the U.S. make extensive use of tax havens. The most
widely publicized use is that of the Netherlands Antilles
for investment in U.S. real estate. Much has been written
on this subject, and it has been extensively studied by
various branches of the Federal Government. It is discussed
in Chapter VIII dealing with treaties. Legislation enacted
in December 1980 will subject foreign persons to tax on
their gain from the sale of United States real property. Often,
foreign investors' use of tax havens is connected with
treaty shopping, which is also discussed in Chapter VIII.

1 . Banks

Foreign banks may use tax havens as investment vehicles
or otherwise in connection with U.S. business.

Foreign banks conduct business in the United States
through branches, agencies, and subsidiaries (a branch takes
deposits, but only in the form of large denomination CD's;
an agency does not accept these deposits). In many cases
foreign banks first came to the U.S. to finance imports to
this country and to finance sales of raw materials to their
home countries. Today, many function as full service
commercial banks, and some U.S. subsidiaries of foreign
banks are among the largest commercial banks.

It appears that most large foreign banks have subsidiaries
or branches in tax havens. While their investments are not
necessarily funneled through tax havens in all cases, havens
nevertheless play an important role in their tax planning.
In a few recent instances, foreign persons have formed a tax
haven corporation to acquire significant interests in major
U.S. banks.

For example, dollars may be loaned to U.S. customers or
to foreign customers. In either case, the loans may be
"booked" at Nassau or the Cayman Islands, and the interest
paid to the home office. The bank often takes the position
that there is no U.S. business income from this type of
transaction, and that any interest paid is free of tax
because of a tax treaty. The reason is that a foreign
corporation engaged in a trade or business within the U.S.
is taxable at normal rates on its income which is effectively
connected with the conduct of a trade or business within the
U.S.— ^ Income from a security (which would include a note)

— / § 882(a).

108

which is from U.S. sources, and derived by a foreign corporation
in the banking business, is treated as effectively connected
income QQly if the securities are "attributable" to the U.S.
office. — loans which are "booked" abroad are not attributable
to a U.S. office, and therefore , the interest from the loans
is not effectively connected. —

under the IRS regulations, it would appear that U.S.
source interest on loans booked overseas is not effectively
connected with the conduct of a trade or business in the
U.S., and therefore the interest is not taxable on a net
basis by the U.S. If the U.S. has a tax treaty with the
home country of the bank, and the interest is paid to the
home country, then the treaty rate of tax (often zero) will
apply. Accordingly, there is no U.S. tax on the transaction.

However, in the case of foreign source interest, the
IRS position is that active participation by the U.S. office
is sufficient to make the income effectively connected. — '

The problems with the foreign source interest rules are
largely administrative. Lack of cooperation in supplying
books and records, and in permitting tax haven employees to
be interviewed, makes it difficult for the IRS to determine
whether the haven company or the U.S. office negotiated the
loan. In addition, the "booking" rule in the effectively
connected regulations makes it easy for a bank to choose the
tax treatment of its U.S. source loan transactions.

2. Insurance

Foreign insurance companies do business in the U.S.
through branches or through U.S. subsidiary corporations.
The trend seems to be toward incorporating the branches.
The IRS Office of International Operations appears to have
no tax haven problems with foreign insurance companies,
although the companies do reinsure a part of their domestic
risk through tax havens (most often Bermuda, but in some
cases the Caymans).

82/

Treas. Reg. § 1. 864-4 (c) ( 5) ( ii ) .

—^ Treas. Reg. § 1. 864-4 (c) ( 5) { iii ) ( 2) .
— ^ Rev. Rul. 75-253, 1975-1 C.B. 203.

109

3. Entertainment Industry

Foreign entertainers appear to make extensive use of
tax havens in structuring their U.S. and foreign business.
An entertainer or a group of entertainers may establish a
corporation in a tax haven with which the U.S. has a treaty
(most often the Netherlands Antilles or Switzerland), and
enter into a long term employment contract with that corporation.
The corporation then contracts with a U.S. promoter to
arrange tours for the entertainers. The proceeds from the
tour are paid to the tax haven company, and that company
then pays the entertainer an annual salary.

The corporation also contracts with a U.S. distributor
for the distribution of records. Profits from the sale of
the records are paid by the U.S. distributor to the tax
haven company, and the company takes the position that the
amounts are royalties and that the treaty benefits apply.
In the case of the Swiss and Netherland Antilles treaties,
this means that the amounts are not taxed by the U.S. This
issue is discussed in Chapter VIII, relating to treaties.

4. Trading and Sales Companies

A foreign corporation may invest in the U.S. through a
tax haven. The treaty shopping issues of this form of
investment are discussed in Chapter VIII.

In some cases, a foreign corporation selling into the
U.S. through a U.S. subsidiary will establish a second
subsidiary in a tax haven. The U.S. subsidiary will sell to
or purchase from the tax haven subsidiary, often at prices
which are not arms length. These transactions should be
subject to a § 482 adjustment. In some cases, however, the
IRS is not aware of the ownership of the tax haven entity,
and therefore an appropriate § 482 adjustment is not made.

This is a problem of administrative detection, which can
probably best be dealt with by good solid auditing. In
addition, a schedule might be prepared to be attached to the
Form 1120 filed by a U.S. subsidiary of a foreign corporation.
The schedule would request information necessary to enable
the revenue agent to consider a § 482 adjustment.

5. Aliens Resident in the U.S.

It is generally believed that there are a large number
of aliens living in the U.S. who claim to be nonresidents,
but who in fact spend substantial amounts of time here and
for all practical purposes might be considered residents.

110

Many of these persons own expensive apartments and have no
other permanent abode. An alien may enter this country as
a tourist, advise Immigration that he will be here for from
60 to 90 days, and then, within the 60 to 90 day period,
leave to travel or to visit his offshore bank. He then
returns and gives Immigration the same story.

The alien will often transfer his assets to a holding
company or a trust located in a tax haven. His money will
be invested in U.S. bank accounts, the Eurobond market, or
in other financial assets. The assets may also be invested
in U.S. real estate. Because the alien claims to be a
nonresident alien and does not consider any of his income as
being from U.S. sources, he does not report any of this
income on U.S. returns.

Aliens are able to avoid tax, and the IRS is unable to
deal with them because of: a lack of reporting; a lack of
information concerning payments to the aliens; a lack of
coherent information disseminated to the IRS; and the absence
of a clear definition of the term "residence."

There is little that can be done about the lack of
reporting of income or obtaining information on receipts of
income, unless a readily administerable definition of residence
is developed and information concerning the comings and
goings of aliens is made available to the IRS.

Under U.S. law, a non-resident alien not engaged in
trade or business within the U.S. is taxed only on his U.S.
source income, but a resident alien is taxed on his worldwide
income. Accordingly, while the determination of resident
status can have an enormous impact, thergj-is no precise
definition of the term. The regulations — ' define a resident
as one "actually present in the United States who is not a
mere transient or sojourner." The length of his stay and
its nature are factors to be considered. No definite rule
is provided. The IRS has, however, ruled that presence igf:/
the U.S. for one year creates a presumption of residence. — '

— '^ Treas. Reg. §1.871-2(b).

— / Rev. Rul. 69-611, 1969-2 C.B. 150.

Ill

VI. Use of Tax Havens To Facilitate
Evasion of U.S. Taxes

The use of tax havens by earners of illegal income
(particularly narcotics trafficers) has generated signi-
ficant publicity over the years. The extent of this type of
use, and the extent of use for tax evasion purposes in general,
is not definitively known. The statistical study undertaken
in connection with the Tax Haven Study has not given us an
estimate of the level of this use although the study does
show enormous and growing levels of financial activity and
accumulation of funds in tax havens.—^

Our study has been able to conclude that there are a
large number of transactions involving illegally earned
income and legally earned income which is diverted to or
passed through havens for purposes of tax evasion. We
identified approximately 250 criminal cases (either currently
active or closed within approximately the past three years)
involving offshore transactions. This number of cases
is an indication of a significant level of use.

Many of the cases identified were closed without prosecu-
tion, often because the evidence was not available to estab-
lish a key element in a case. Almost every case involved
either an offshore entity such as a trust or corporation or
a foreign bank account.

A fair statement of the problems in dealing with this
type of activity is that of Assistant Attorney General (Tax
Division) Ferguson in his statement to the Oversight Com-
mittee of the Ways and Means Committee:—

"As you might expect, evasion
of United States taxes through sham
business transactions involving foreign
entities is difficult to detect, hard
to recognize when found, and, where
foreign witnesses and documents are
crucial, sometimes impossible to prove
in court. Even the most transparent

1/ See Chapter III, infra,

2J The Use of Offshore Tax Havens for the Purposes of

Evading Income Taxes; Hearings Before the House Sub-
committee on Oversight of the Committee on Ways and
Means, 96th Cong., 1st Sess. 18 (1979).

112

transactions are likely to have
sufficient documentation to satisfy
a surface inquiry by an auditor and
enough complexity to discourage a
deeper look. Furthermore, being
dependent on form and multiplicity
of steps, such transactions will
utilize entities in tax haven juris-
dictions offering business and banking
secrecy to conceal their lack of
substance. "

A. Prior Efforts To Investigate Offshore Cases

Over the past two decades, Revenue Agents and Special
Agents have conducted a number of investigations involving
tax havens.

During 1957 and 1958, special agents in the Manhattan
District attempted to establish the identity of persons
making large deposits of currency in New York banks for
subsequent transfer to secret (numbered or coded) Swiss bank
accounts. During one three month period, a New York bank
filed 81 currency forms reflecting deposits of $1.1 million
under 77 different names and addresses. These deposits were
transferred to coded accounts in specified Swiss banks.
Investigation by eight Special Agents revealed that all 77
names and addresses given to the bank by the depositors were
fictitious; the depositors could not be located.

Follow-up investigations of other currency deposit
forms did locate depositors who had transferred funds to
numbered Swiss bank accounts. The reasons for maintenance
of the accounts ranged from engaging in complicated inter-
national commercial transactions to political refugee situ-
ations. Although it was suspected that some of these trans-
actions involved tax evasion or other violations of U.S.
law — including narcotics, securities law, and smuggling--the
inability to secure information on the accounts from Switzer-
land contributed to the lack of success in developing any
cases for prosecution.

The investigations served to increase concerns of law
enforcement authorities about the potential for using secret
foreign bank accounts for illegal purposes, and suggested a
need for tighter regulation or better reporting of inter-
national currency transfers. Accordingly, during the summer

3/ Forms TCR-1 (predecessor of Form 4789).

113

of 1960, a conference was held in the National Office of IRS
to develop means for controlling illicit international money
flows. None of the ideas put forth at the conference was
implemented, in part because they required legislation. It
was felt that the lack of proof that secret foreign bank
accounts were in fact being used for tax evasion purposes
made prospects poor for legislation to require improved
reporting on international currency transfers.

From 1966 through early 1967, IRS agents worked with
the U.S. District Attorney for New York City, who was then
conducting a grand jury investigation of the use of foreign
banks by suspected "underworld" figures. IRS agents assisted
in examining bank records and correspondence of taxpayers
who opened and funded Swiss accounts by making deposits in
U.S. branches of Swiss banks. In early 1967, a task force
was formed to coordinate Examination, Criminal Investigation
and Office of International Operations activities regarding
secret foreign bank accounts. Although these efforts improved
IRS knowledge of the use of secret foreign bank accounts,
audits of 130 taxpayers identified via grand jury investi-
gation were disappointing in terms of taxes collected, due
to lack of adequate documentation and perhaps also due to
the inexperience of audit personnel in dealing with cases
where pertinent records were beyond the reach of U.S. law.

As an outgrowth of these efforts, a project known as
"Swiss Mail Watch" and later as the "Foreign Bank Account
Project", was initiated to identify U.S. taxpayers receiving
mail from Swiss banks. From January 8 to May 2, 1968, with
the assistance of the postal authorities, IRS monitored mail
received in a New York post office. Swiss bank mail was
identified by the postage meter numbers used by the Swiss
banks, and the outside of envelopes mailed by the Swiss
banks to individuals and firms in the U.S. was photocopied.
From this monitoring, a list of 8,500 taxpayers was prepared,
from which 168 taxpayers were selected for audit by 16
agents in two districts. The audits resulted in the assess-
ment of about $2 million in taxes and penalties, less than a
third of which was attributable to the foreign bank accounts.
The audits indicated that only about a fifth of the tax-
payers used their Swiss accounts as a depository for unreported
income or to avoid the interest equalization tax, and that
the unreported income in such cases was not substantial.
Because of the inability to obtain corroborating testimony
and documentation from the Swiss banks, no prosecutions
resulted.

114

Subsequently, two more mail watches were initiated, one
(during the period January 2 through February 2, 1969, and
the last from December 27, 1970 through February 4, 1971.
The 1969 mail watch identified about 21,500 taxpayers who I

appeared to have Swiss bank accounts, and the 1971 mail |

watch identified another 20,000 to 25,000 taxpayers who |

appeared to have such accounts. However, no IRS audit was i

initiated as a result of these later mail watches.

The Foreign Bank Accounts Project was discontinued for \

a combination of reasons. A mutual assistance treaty was
being negotiated with Switzerland which, it was hoped, would '
permit Swiss banks to provide bank account information about
Americans suspected of crimes. It was believed that use of I

the mail watch data would jeopardize the treaty negotiations.
In addition, a Senate Subcommittee on Constitutional Rights
was raising questions about the propriety of developing com-
puterized files of suspected tax violators. Finally, some
officials believed that the audit results, and failure to
develop prosecution cases, were disappointing in terms of
resources expended; staff costs were estimated at 2,318
staff days, at a salary of $260,000. They also believed
that this technique did not offer a long-term solution to
the foreign bank account problem. The issue was also being
addressed by the House and Senate Banking and Currency
Committees; the result was the enactment of the Bank Secrecy
Act— on October 26, 1970, which became effective upon publication
of implementing regulations in July 1972.

Other investigative efforts were initiated during the
1960s and early 1970s. One was an investigation (sometimes
referred to as the "Bahamas Project" ) of a West Coast attorney
who appeared to be promoting the use of tax havens to evade
the taxes of well-to-do clients. A lengthy examination
resulted in criminal prosecution, and a trial that lasted
six months. The attorney was acquitted, but hundreds of
civil tax cases, involving over $100 million in taxes,
resulted against his clients. Most of these civil cases
are still pending in the Tax Court.

In another effort, a special agent from the IRS Reno
District established liaison with a police department official
of Grand Cayman Island, who subsequently furnished limited
information concerning bank accounts of U.S. citizens. This
effort, called "Project Pirate," was terminated in 1975.

4/ P.L. 91-508.

115

Records do not indicate that any successful audits or crim-
inal prosecutions resulted from this information. In 1976,
the Caymans strengthened their bank secrecy laws, making it
a crime for any person to reveal information about bank
accounts in the Cayman Islands.

The above investigative efforts were examined in con-
siderable detail in several Congressional hearings. These
hearings gave principal attention, however, to an effort
termed "Operation Tradewinds," and to an offshoot termed
"Project Haven."

Operation Tradewinds was an information gathering
effort by IPS agents in the Jacksonville, Florida District
to obtain information from Bahamian bank employees about the
identity of U.S. taxpayers using Bahamian trusts and bank
accounts. Information was obtained from informants passing
on the information through Americans acting as intermediaries
to IRS agents.

Operation Tradewinds produced considerable useful
information, resulting in audit deficiencies recommended in
45 cases, and several criminal prosecutions, before the
operation was suspended in January 1975. It also developed
the information which gave rise to Project Haven.

Project Haven was initiated in 1972 in connection with
an investigation of a narcotics trafficker, who it was
learned had dealings with a Bahamian bank. A confidential
informant was used to obtain Bahamian bank documents regarding
this individual; in the process the informant learned that
the Bahamian bank was receiving and disbursing funds on
behalf of U.S. citizens whose identities were not revealed
to the correspondent U.S. banks in Miami, New York, and
Chicago.

The confidential informant, having developed a social
relationship with a Bahamian bank official, learned that the
bank official was planning to travel to the U.S. in January
1973, with a stop-off in Miami. At the banker's request,
the informant arranged a date for the banker. While dining
out, the banker left his briefcase in his date's apartment.
She had previously given the informant a key to the apart-
ment. The informant entered the apartment, removed the
briefcase, had it opened by a locksmith, and made the docu-
ments therein available to IRS agents for photocopying.
After photocopying, the documents were replaced and the
briefcase returned to the apartment, all without the banker's
knowledge.

116

The documents identified over 300 U.S. citizens and
firms having accounts with that Bahamian bank. A large
number of civil and criminal investigations were initiated
on the basis of this information. The criminal cases (about
6 dozen in all) were initially investigated by several grand
juries, and were finally consolidated in 1975 under one
grand jury in the Southern Judicial District of Florida.
One of the criminal cases reached the Supreme Court,— which
ruled that the defendent lacked standing to object to admiss-
ibility of evidence obtained by the "briefcase caper," since
the defendant's (as distinguished from the banker's) con-
stitutional rights were not violated.

B. Narcotics Related Cases

Much of the concern with tax havens centers on their
use by narcotics traffickers. Over the past few years there
have been numerous Congressional hearings directed at
problems involving the use of havens by narcotics traffickers.
The press has, from time to time, reported on alleged use.

Tax havens are ideally suited to the purposes of the
narcotics trafficker. The trafficker's goal, once he has
sold his product, is to cleanse his money or to hide it so
that he can put it to use without it being attributed to him
as unreported income. A tax haven facilitates achievement
of this goal by providing a veil of secrecy over parts of
the transaction, so that the taxpayer cannot be definitely
tied to the flow of funds. Furthermore, the tax haven's
infrastructure, which often includes modern banking and com-
munications facilities, serves to facilitate rapid movement
of funds.

The problem can be illustrated by a simple case. A
narcotics trafficker arranges for a carrier to carry $50,000
cash in a suitcase to the Cayman Islands, where it is deposited
in a small private bank. The small bank then transfers the
money to an account at the branch of a large money center
bank. The U.S. narcotics trafficker then borrows $50,000
from a Canadian bank. Both the U.S. trafficker and the
Canadian bank claim the loan is simply a signature loan to
the individual. In fact, the loan is effectively secured by
the Cayman deposit. The IRS, however, is unable to establish
the connection and therefore cannot prosecute. The IRS may
be able to identify the money leaving the U.S. by use of

5/ united States v. Payner , 46 AFTR 2d 80-5174 (1980)
rev'g 590 F. 2d 206 (6th Cir. 1979).

117

currency transaction reports and records of wire transfers.
It may see the money entering the U.S. The veil of secrecy
prevents tying the two together. While Canada might give
the U.S. information pursuant to a treaty request, the
information may not be sufficient to tie the taxpayer to the
Cayman account. To a great extent, it is the highly developed
and sophisticated banking and communications infrastructure
in the tax haven which makes it possible to move the money
swiftly and efficiently.

In general, there does not appear to be much that is
new or exceptionally sophisticated in the methods used by
narcotics traffickers to move their money. For example, in
a standard pattern a courier deposits cash in a U.S. bank
and the money is then wired to a haven bank account. From
there it can be moved with relative ease.

Many narcotics cases do not involve offshore trans-
actions at all. In addition, in some cases foreign juris-
dictions which are not tax havens are utilized. For example,
Mexico and Canada have been used because of their proximity
to the U.S. and perhaps because of their lack of taint. A
transaction with the Cayman Islands is suspect; a trans-
action with Canada is not. Our current investigations
indicate, however, that many narcotics transactions do
involve offshore activity. The Florida Cash Flow Project
has uncovered some.

It would appear that the most effective methods for
dealing with narcotics traffickers have been intensive well
coordinated inter-agency grand jury investigations. These
investigations have the advantage of enabling one person
(the Assistant U.S. Attorney) to provide direction and
coordination. They also enable agents from various agencies
to work more closely together with a common goal. Further-
more, a joint investigation brings together a number of
different disciplines and expertise. Finally, it enables
the IRS to avoid some of the coordination problems caused by
the disclosure rules of § 6103.—

Other successful methods of uncovering large scale
narcotics operations have involved the use of informants or
undercover operators to launder money through financial
institutions.

6^/ See , for example, "Narcotics Agents Track Big Cash
Transactions to Trap Dope Dealers", The Wall Street
Journal, November 26, 1980, A-1.

118

Caution must be exercised in applying resources in the
narcotics area. The CID agent is a highly trained financial
investigator who is capable of dealing with sophisticated
cases. Too much pressure to apply resources without identi-
fying adequate and proper cases could lead to a waste of
these valuable people by having them recommending term-
ination assessments against low level drug dealers. This
kind of problem was encountered in the early 1970's, and in
the opinion of some resulted in some overreaching. The use
of termination and jeopardy assessments at one time or
another became disproportionate.

C. Patterns of Use of Tax Havens for Evasion

A brief description of the general categories of trans-
actions which we identified follows. In many of these
cases, the only reason prosecution was possible was because
an informant was available.

1. Double Trusts

The IRS has under investigation a number of promoters
of so-called double trusts or family estate trust schemes.
There are at least two grand juries and numerous civil
investigations. The schemes seem to be concentrated in the
western part of the country.

The schemes, while differing somewhat from promoter to
promoter, generally involve having an unrelated party set up
a trust in a haven. The first trust then sets up a second
trust which it designates as the beneficiary of the first
trust. Some promoters also use a third trust. The U.S.
taxpayer may appoint himself as the trustee of the first
trust, and then appoint the first trust the trustee of the
second trust, and so on. The U.S. person transfers his
assets or his right to earn income, or both, to the first
trust in exchange for certificates of ownership. The income
then flows to the second trust, which may make "gifts" or
"loans" to the U.S. taxpayer.

Some of the returns indicate that the offshore entity
is purchasing supplies and selling them to the U.S. party at
an inflated price. The profit is being accumulated in the
haven, or is being returned to the taxpayer as gifts or
loans.

There is no way of knowing how many persons having an
interest in these trusts have dropped out of the tax return
filing population.

119

2. Secret Bank Accounts

Generally, these cases involve unreported income being
diverted to a bank account located in a tax haven. Many of
the taxpayers under investigation are alleged narcotics
traffickers. The money is most often diverted from the U.S.
by physically removing it from the country or by wire trans-
fers. If money is diverted by wire transfer it must first be
deposited in a U.S. bank. A currency transaction report may
have to be filed by the bank. However, the depositor may give
a fictitious name, or may simply leave the country before
a report can be investigated.

In one case, the taxpayer was the sole shareholder of a
corporation which acted as a sales agent for a major foreign
corporation. The taxpayer's corporation received commissions
for the sales activities performed, which were properly
recorded on the books of the corporation. However, the
corporation received additional commission payments from the
foreign corporation which were not accounted for on its
books and records. Pursuant to a direction by the share-
holder, these additional commissions were wired by the
foreign corporation to a numbered bank account in Switzerland
maintained by the taxpayer. The special agent examined the
records of the foreign corporation, which indicated that the
wire transfer had been made, and also interviewed foreign
corporate officials who stated that the taxpayer had directed
them to transfer the funds into the numbered Swiss bank
account. However, the foreign corporate officials subsequently
refused to cooperate, and prosecution of this case had to be
declined by District Counsel due to the lack of available
witnesses and documentary evidence subject to the compulsory
jurisdiction of the United States courts.

In another case recently prosecuted by the United
States Attorney's office, the United States was able to
successfully prove that corporate receipts had been diverted
to a foreign bank account. In this case, a United States
corporation purchased machinery and equipment from a Puerto
Rican corporation. The purchase agreement and the payments
made were properly reflected both on the books of the cor-
poration and on the corporation's tax return. However,
additional agreements had been entered into, in connection
with the purchase of the machinery and equipment, which were
not reflected on the corporate books and records or on the
tax returns. These agreements provided that if the machinery
and equipment sold to the U.S. corporation were not delivered
by a certain date, then the Puerto Rican corporation would
be liable for lease payments at a stated rental per month.
When the Puerto Rican corporation failed to deliver the
equipment and machinery on the specified date, it became
liable for the rental payments which were subsequently paid.

120

In receiving payment, the U.S. corporate officials
arranged it so that the proceeds from the payment were used
to purchase certificates of deposit in a nominee name in
Puerto Rico. Subsequently, the proceeds from these certificates
of deposit were deposited in a bank account in the Cayman
Islands, in the name of a Cayman corporation whose stock was
held by nominees. The amount in the Cayman bank account was
eventually divided up among the corporate officials, in
proportion to their stock ownership.

The corporate offical who masterminded the scheme, an
attorney familiar with the methods used by the IRS to
prosecute tax crimes, advised the other participants that
the money from the bank account should only be spent in such
a way so that it left no trace, in order to avoid the IRS'
making a net worth and expenditures case against the shareholders.

Successful prosecution in this case was made possible
by an informant, an uninvolved corporate employee, who
furnished the IRS with information of the details of this
scheme, as well as with copies of bank statements for the
Cayman Islands bank account and with an agreement drawn up
by a Cayman Islands attorney reflecting the fact that the
nominal shareholders of the Cayman corporation were merely
acting as nominees for the corporate officals. Other corporate
officials also testified at the trial under grants of pro-
secutorial immunity.

Also involved in this case was the use of a corporate
jet to ferry cash secretly out of the country. In this
scheme, the corporation sold component parts of heavy con-
struction equipment for cash, without reporting the sales of
the components on the books and records of the corporation.
The pilot of the corporate jet would then meet someone at a
U.S. airport who would hand him a brief case. The pilot
was instructed to fly to the Cayman Islands and to give the
brief case to an attorney. The brief case contained cash
representing the unreported sales proceeds, and was deposited
by the Cayman Islands attorney in the secret bank account
mentioned above.

3. U.S. Taxpayers Using a Foreign Corporation - Substance
Over Form

In some cases, taxpayers form corporations in tax
havens, ownership is not denied, and the required returns
are filed. Cases may, for example, involve sales subsidiaries.
In at least one case, a large company had formed and used a
captive insurance company. Most of the recommendations for
prosecution were declined either by Chief Counsel or the Tax
Division.

121

Other cases appear fraudulent but necessary evidence
cannot be obtained. In a recent routine civil examination
of a return, it was discovered that substantial amounts had
been deducted as business expenses relating to rental property
which was not owned by the taxpayer. Upon further examination,
it was discovered that the rental property was owned by a
trust with the trustee being a bank located in a Caribbean
tax haven. The taxpayer was listed as the United States
agent for the trust. It was also determined that the taxpayer
was listed as the agent for the bank, which was the sole
shareholder of several corporations doing business in the
United States with which the taxpayer had formerly been
associated. Because information was received that the
taxpayer had unreported consulting fees, as well as unreported
capital gain income, the case was referred to Criminal
Investigation for investigation.

During the investigation, it was determined that returns
had been filed by all of the corporations and trusts, and
reflected the items of income and expense involved. No
evidence was produced to substantiate the allegations of
unreported consulting fees or unreported capital gain income.
However, since the taxpayer refused to cooperate, and because
of commercial secrecy laws in the Bahamas, no information
could be obtained concerning the trusts or the corporations
and their relationship to the taxpayer. In addition, no
financial records of any of these organizations could be
examined to determine if unreported income of the taxpayer
was being diverted to these entities. Accordingly, because
of the lack of evidence to substantiate allegations of
unreported income, and because, at most, the case involved a
question of substance over form. District Counsel and Crim-
inal Investigation agreed that the investigation should be
discontinued.

4. Shelters - Commodity Transactions

We have identified a number of cases where offshore
entities or locations were used to faciliate alleged com-
modity transactions. Generally, these are so called "tax
spreads" which seek to give the investor a tax advantage by
generating large ordinary losses in year one, and then long-
term capital gain in year two. The benefit to the taxpayer
is the difference between the tax saved on the ordinary loss
and the tax paid on the capital gain. A tax haven entity may
be used in these schemes to conceal the fact that transactions
never take place, or to conceal the promoter's profit. Some of
these transactions were discussed in Chapter V, supra. , and
an option for dealing with these schemes on a technical
basis is presented in Chapter VII, infra .

122

5. Income Generated Overseas Deposited in a Foreign Bank Account

A taxpayer who was an employee of a large United
States multinational tire and rubber manufacturer, through
the use of a nominee bank account in Switzerland, was able
to receive large amounts of kickbacks, from sellers of raw
materials to his employer corporation, which were deposited
in the Swiss bank account and which were not reported for
federal income tax purposes.

The taxpayer approached a seller of natural rubber and
suggested that the seller have one of its subsidiary companies
increase the sales price paid by the employer company for
rubber purchased from the subsidiary. The increased sales
price would then be partially kicked back to a subsidiary of
the employer corporation, with the difference between the
amount of first kickback and the increased purchase price
being transferred to a Swiss bank account.

In order to avoid having the Swiss bank account traced
to him, the taxpayer persuaded an officer of the foreign
selling corporation to set up the bank account in the officer's
name. The foreign corporate official made arrangements with
the Swiss bank so that the taxpayer had full authority over
the account. The initial deposit to this account was $25,000.

In addition to this arrangement, the taxpayer also
arranged to have kickbacks paid by another corporation which
sold raw materials to his corporation. This second kickback
scheme was falsely recorded on the books and records of the
selling corporation. Records of this corporation indicated
that the amounts which were kicked back represented consulting
fees paid to the first foreign corporate official mentioned
above. Checks were made in the name of the foreign corporate
offical and were deposited to the Swiss bank account which
bore his name. Subsequently, the taxpayer or an agent of
his withdrew these amounts from the Swiss bank account. The
amount of kickbacks which were deposited and withdrawn based
upon this scheme amounted to $220,000.

The foreign corporate offical was unaware of this
scheme with the second selling corporation. In point of
fact, he was not a consultant to the selling corporation nor
had he received any of the monies in question, all of which
had been withdrawn for the use of the taxpayer. This case
resulted in a successful criminal prosecution. The taxpayer
was sentenced to three years imprisonment.

123

6 . Slush Funds

Most of these cases were identified in the mid 1970's.
They generally involved large companies which were facili-
tating the payment of bribes or kickbacks to persons in
foreign countries, who assisted in the sales of products by
the U.S. company. Usually, the slush fund money was generated
by increasing the contract price and having the excess paid
into a foreign account. In most cases the funds used for
the bribes were generated overseas. Other cases involved
payments to sales agents in a foreign country, with the
commissions being funneled to foreign government officials.

Most of these cases appear to have been developed from
data provided by the company to the Securities and Exchange
Commission as part of a voluntary disclosure program. The
IRS initiated approximately 200 criminal investigations.
Only about four of these cases resulted in a conviction or
a plea of guilty.

7. Use of a Foreign Entity To Step-up the Basis of U.S.
Property

A number of cases have been identified where a foreign
entity was apparently used by a U.S. taxpayer to step-up his
basis in property and thus obtain higher depreciation
deductions on his U.S. tax return. In one case, a shelter
promoter allegedly established a Cayman Islands company.
The promoter then purchased slum property and sold it to the
Cayman entity at a low price. The Cayman entity sold the
property to a U.S. limited partnership at a greatly inflated
price in exchange for cash and notes. The limited partner-
ship then marketed interests in the slum property.

8 . Repatriation of Funds

One problem that the tax evader faces is obtaining the
use of funds which he has failed to report as income.
Various schemes are resorted to so that the taxpayer can
justify his use of the funds.

In one case, agents of an alleged narcotics dealer
placed $2.5 million in the Panamanian account of a Panamanian
corporation. The Panamanian company had a U.S. subsidiary
which it capitalized by cash contributions. The U.S. company
had made major investments in the U.S. The taxpayer was a
salaried employee of the U.S. company.

124

Perhaps the most common form of repatriation of evasion
money is a loan from a foreign entity to the taxpayer. In
one case IRS was able to track deposits into a Canadian
bank which had a branch in the Cayman Islands. The loans
were fully documented, but the authenticity of the documentation
was questionable. There was no proof which would be admissible
in court of the connection between the Cayman deposits and
the Canadian loans. Without evidence from the Cayman Islands,
we cannot refute the authenticity of the loans. In another
case, the taxpayer's lawyer told the IRS agent that any net
worth figures that they developed could be explained through
fully documented loans. The agent was told that the loan
papers would be produced when the allegations were made.

Another pattern is for a tax haven entity to make payments
to third parties on behalf of the taxpayer. Still another
method of using the funds is to make indirect payments for
the benefit of children or relatives of the taxpayer. This
is often done through a trust disbursing the funds. In one
case a closely held U.S. company owned a valuable asset.
The asset was sold to a Cayman Island trust which had as its
beneficiary the children of the shareholders of the U.S.
company. The corporation then licensed the asset back from
the trust and paid substantial license fees to the trust.
It was alleged by the taxpayer that an unrelted party controlled
the trust. This could not be refuted because of the unavailability
of witnesses and records from the Cayman Islands.

D. Informants and Undercover Operations

Informants are a useful means of developing leads in
havens. Often, they are the only vehicle with which to
breach the wall of secrecy. Even if an informant cannot
supply documentary evidence, leads developed from information
supplied by an informant may often provide the missing
pieces in an investigation. In the case of a narcotics
related investigation or an organized crime case, an informant
may be the only lead with which to develop a case worthy of
prosecution.

IRS special agents are advised that informants are
often necessary in order to complete an investigation and
acquire .essential evidence. This can include "undercover
work".— Since 1977 CID has held regional and district

7/ See IRM 9372.1.

125

seminars on developing, handling, and paying informants. In
order to place new emphasis on the need to develop informants,
CID has prepared a new film which, after some testing, will
be disseminated nationally. This film presents the latest
techniques for identifying informants, extracting information
from them, controlling informants, and making payments to
informants. It also highlights the pitfalls which must be
watched for in dealing with informants.

The IRS is authorized to pay rewards for information
leading to the detection and punishment of any person guilty
of violating the tax law.- The payments are generally
limited to 10 percent of the additional taxo^penalties, and
fines collected because of the information.—

In addition, the IRS can pay informants for specific
information or to lay the-qroundwork for the later pro-
curement of information. — ' The instructions to the special
agents also provide for "confidential expenditures" for the
purchasing of information. — ' They also make clear that it
is the policy of the IRS to maintain the confidentiality of
the identity of informants and that superiors, while they
have a right to know who an informant is, will generally not ,„ ,
inquire as to his identity unless the knowledge is necessary. — '

Since 1977 the IRS has developed an increased number of
cases by the use of informants. The number of cases initiated
because of information furnished by informants has grown
from 25 in 1977 to 72 in 1979, and the number of cases
opened because of information supplied by informants has
grown from 64 in 1977 to 187 in 1979. Because of procedures
developed to protect the identity of informants, the extent
of the use of informants to investigate offshore cases
cannot be disclosed. However, there are no restrictions on

8/ § 7623.

9/ Treas. Reg. §301.7623-1 (c).

10/ See IRM 9772.

n/ See IRM 93 72.2.

12/ IRM 9373.1.

126

the development of offshore informants, at least if they are
controlled in the U.S. In fact, the recent training film
dealing with developing informants, while not specifically
discussing developing offshore informants, does use as a
example a case involving laundering of money through an
offshore jurisdiction.

The IRS has also been involved in undercover operations,
both alone and in conjunction with other agencies. Where
necessary, the IRS has made funds available to use in those
operations.

In one case reported in the Dallas Morning News , Miami
Herald , and the Cayman Compus , the IRS cooperated with the
Drug Enforcement Administration (DEA) in laundering $50,000
of IRS money through a Cayman Island bank. According to the
press reports, DEA agents posed as drug dealers and approached
a Dallas businessman who told them that he could supply them
with cocaine and hashish and could advise them of a "fool
proof scheme to legitimize the illegal profits and make them
tax exempt at the same time". The businessman introduced
the agents to a Dallas attorney who formed a U.S. company
for them, took them to the Cayman Islands to a phony loan
company, deposited their $50,000 in a bank and then withdrew
$46,222, keeping a six percent service charge and a small
Cayman Islands tax. A check in the amount of $46,222 was
drawn on the phony loan company and made payable to the
U.S. company. The attorney then brought the check back into
the united States. Once back in the United States, according
to the newspapers, the attorney made out phony records to
show that the amount of the check was a loan to the U.S.
company from the Cayman company at six percent interest.
According to the paper, the undercover agents were told to
pay themselves liberal salaries, expense reimbursements, and
annual bonuses, and to drive company owned cars and deduct
the loan interest from their federal income taxes.

The DEA and IRS agents then followed the businessman to
Miami where he was eventually arrested and "charged with
smuggling currency and with possession of cocaine with
intent to distribute." The attorney was also arrested and
charged with smuggling currency out of the country. According
to an article which appeared on December 20, 1977, in the
Cayman Compus the phony loan company was under the manage-
ment of a Cayman company.

127

E. Analysis

The IRS and the Department of Justice encounter sig-
nificant problems when trying to investigate or prosecute
cases involving tax haven transactions.

It is difficult, if not impossible, to obtain admissible
evidence connecting the U.S. taxpayer with an income item in
such cases. For example, in the Canadian loan case described
above, there is circumstantial evidence which might tie the
taxpayer to the money. However, there is no admissible
evidence directly tying the taxpayer to the funds. Often,
ownership of an entity cannot be proven. For example, in a
number of the schemes described above, there are transactions
which go through an offshore entity which appears to be •

accumulating a significant amount of money. While the money J

may accumulate for the benefit of a U.S. person or be used '

by him in some way, there is no available evidence to connect j

him with ownership of the entity. General information j

gathering problems and options for dealing with them are

discussed in Chapter IX. J

«

There are also administrative problems. The level of j

coordination of offshore cases is unclear. In at least one \

case, promoters of a scheme were being independently investi- J

gated in two separate districts. Problems of coordination j

are discussed in Chapter X. <

4

Another problem is the identification of cases for \
investigation. Many offshore cases are technically difficult
from a legal perspective, and the facts are difficult to ' . J

sort out. A number of cases which were thoroughly investi- '

gated, after the expenditure of signficant time and money, ^
turned out to involve lawful business arrangements, although ' i

legal issues such as pricing or allocation of expenses may \

be present. This problem, and the possibility of providing i

legal assistance to the agents during the course of an 4
investigation, are addressed in Chapter X.

Options are presented in Chapter VII for technical changes,
both administrative and legislative, which might help ration-
alize the taxation of tax haven transactions and accordingly
might limit some fraudulent use.

128

VII. Options for Change in Substantive Rules

Many of the transactions described in Chapter V are
perfectly legitimate and reflect Congressional policies as to
Uhited States taxing jurisdiction. In many cases, decisions
to change those policies should not be made without thorough
economic analysis; such analysis is beyond the scope of this
report. Nevertheless, there are both administrative and
legislative changes which can be made which might help to
curtail some of the tax haven use and ease the government's
administrative burdens in this area. Options dealing with
tax haven income tax treaties, with information gathering
problems, and with internal IRS structure are dealt with in
Chapters VIII, IX and X, respectively.

The transactions described in Chapter VI are fraudulent,
and, in general, will not be prevented by changes in substantial
rules. However, better administrative efforts and more rational
tax rules might discourage some fraudulent use, and might make
fraudulent use easier to detect.

A. Options Which Can be Accomplished Administratively

While it may be advisable to make some legislative
changes, decisions to change the Code should be made only
after thorough analysis. Additional rules generally bring
more complexity, and may make the process more difficult
for both taxpayers and tax administrators. The options
discussed below could be pursued without changes in legislation.

1. Burden of Proof

Many of the cases described above involve a U.S. person
taking a deduction for an amount paid to a tax haven (e.g. ,
shelter transactions). Agents often spend significant time
attempting to determine whether the taxpayer has in fact
incurred an expense, or whether an offshore piece of property
is correctly valued. The same problem occurs in pricing
cases where taxpayers fail to establish that the price which
they charge is the proper price, or with allocation of
deduction issues where foreign taxpayers refuse to produce home
office books adequate to establish the proper allocation of
home office expenses to the U.S.

The burden of proof to establish the tax consequences
of a transaction is on the taxpayer. IRS agents should be
given clear direction that they should deny deductions where
a taxpayer has not established entitlement to the deduction,
or where valuations or proper pricing have not been established.
A series of rulings advising taxpayers that the IRS will
take this position should be published. An initial step in
this direction was taken in Rev. Rul. 80-324.—

1/ 1980-48 I.R.B. 20.

129

2. Section 482 Regulations

Consideration should be given to establishing a regu-
lations project to analyze the §482 regulations, with a view
toward amending them to ease some of the administrative
burdens placed on taxpayers and the IRS, and to achieve
greater certainty in pricing international transactions.

Section 482 is one of the most important provisions
available to the IRS to deal with tax haven transactions.
The regulations take the position that transactions between
related parties are to be conducted at arm's length. If
they are not, and taxable incomes are thereby understated,

the IRS can make allocations to determine the2t.rue taxable ,

income of each member of an affiliated group.— The regulations '

set forth rules for determining taxable income in five •

specific situations.— In each, the method to be used is a j

price which would have been charged an unrelated person. In
a transaction involving a sale of goods, for example, this
is referred to as the "comparable uncontrolled price".—

Taxpayers and IRS agents have had difficulty in dealing |

with the §482 regulations, in part because of the dependence }

upon comparable uncontrolled prices, which often are difficult i

to find, and in part because of the subjective judgments *

which need to be made. Some believe that in a number of I

cases IRS agents disregard the ordering rules in the regula- '

tions for determining the method to be used, and instead go )

to some more general method sooner than they should.— The )
Internal Revenue Manual directs the agents to perform a

"functional analysis" to determine the relative values of ,

the respective functions performed by the two related entities !

involved in a transaction.— j

2/ Treas. Reg. §1.482-2 (e) (2).

3/ Treas. Reg. §1.482-2.

4/ Treas. Reg. §1.482-2 (e) (2).

5/ See, J. Burns, "How IRS Applies the Inter-Company
Pricing Rules of Section 482: A Corporate Survey",
52 J. of Tax. 308 (May 1980).

6/ IRM 4233, Text 623.

130

The inconsistency between the two approaches, and the
problems caused both taxpayers and the IRS, can be seen by
contrasting the approach taken by the courts in the Du Pont

J/

approach taken by the courts in
U.S. Steel case.— In Du Pont tl

case— ^ and the U.S. Steel case.— In Du Pont the court
seemed to be saying that the IRS failure to use a pricing
approach set forth in the regulations was permissible, but
the taxpayer was obligated to prove its case under the
regulations.-/ In U.S. Steel the court seemed to be saying
that the regulations as drafted required the IRS to use
comparables, when they exist, even if they are not precisely
comparable. — ^ These cases, and the cited articles, point
out significant problems which deserve attention. In both
cases, tax havens were involved.

While the §482 provisions are extremely important
in dealing with tax haven problems, and while the cases
cited above involved tax havens, it is beyond the scope of
this report to recommend particular solutions, because these
regulations present major issues involving all international
transactions, most of which occur with countries which are
not tax havens. Instead, a major study should be undertaken
to identify problems and recommend solutions. Any such
study should involve the outside business community, which
will be greatly affected by changes in the §482 regulations.
The General Accounting Office has completed a study of the
administration of §482; its report should be published in
early 1981. Also, the IRS National Office Examination
Division is in the midst of a two year study of the adminis-
tration of §482. In any event, the issues need to be debated
and resolved.

2/ E.I. Du Pont de Nemours and Company , 608 F. 2nd 44 5
(Ct. Cls. 1979).

^/ Uiited States Steel Corp. v. Commissioner , 617 F.2d
942 (2nd Cir. 1980).

9/ See , Fuller, "Problems in Applying the §482 Inter-
Company Pricing Regulations, Accentuated by Dupont
Case", 52 J. of Tax. 10 (January, 1980).

10 / See , Decelles and Raedel, "Use of Comparability
Test in Inter-Company Pricing Strengthed by U.S.
Steel Case", 52 J. of Tax. 102 (August, 1980).

131

In the course of any such study certain approaches
might be considered. iFqc example, a profit splitting approach
has been recommended. — ' under this approach the IRS would
look to functions performed by each of the related entities
involved in a transaction and would attempt to split the
profits between them. In effect, this was in part the
approach which the court in the Du Pont case seemed to accept.
Whether such an approach is feasible, and if so, whether it
should be an alternative to an arm's length standard or
should be applied only if an arm's length price cannot be
found is something that needs to be considered. A disadvantage
to this approach is the need to make subjective judgements
and to apply significant audit time in performing a functional
analysis. The IRS has particular problems today doing this,
especially where a taxpayer refuses to cooperate. ;

J

In addition, some commentators suggesting a profit |

splitting approach assume that intercompany pricing really J
involves which country gets to tax which portion of the

profits from a transaction, and that accordingly profit •

splitting is the issue. Where a tax haven is involved, \

however, this may not be the case, instead the issue may be J

whether the profits are taxed at all. It may be decided I

that a profit splitting approach is not adequate where a tax j

haven is involved and that special rules should apply to tax \

haven transactions. i

Another problem with adopting new §482 rules which |

depart radically from the present rules is that the OECD has j

recently published a report which describes generally accepted '

practices to determine transfer prices. — ' The practices •

set forth are very similiar to the present §482 regulations. \

The hope was that the report would encourage geater uniformity )

among OECD countries in transfer pricing, and accordingly ]

would reduce conflicts. Changes in the regulations would i

retard this process. 3

«
Another approach is a unitary or formula system, which
is used by a few of the states. However, such a system would
completely violate the separate accounting concept under
which many multinational companies operate. It is contrary
to the way most other OECD countries approach transfer
pricing, and contrary to the taxation by the U.S. of other
transfer payments such as those imposed on fixed or determinable
income.

11/ See , for example. Fuller , supra at 11.

12 / OECD, Transfer Pricing and Multinational Enterprises,
Re por t of the OECD Committee on Fiscal Affairs (1979)

132

A sense has developed that foreign multinational
coinpanies are competing against U.S. businesses in the U.S.
and using tax havens to do this. They are often at a competitive
advantage because the §482 regulations were not drafted with
foreign investors in mind. We have seen cases where it is
even unclear that a U.S. company owned by a foreign person
is dealing with a related party in a tax haven, because it
is often difficult to develop the facts to indicate affiliation.

Obviously, if a decision is made to revise the §482
regulations, the goal would be to develop workable rules
which would enable a true and accurate allocation of income
to be made.

Problems with income from the performance of services
might also be dealt with through changes in the §482 regu-
lations, even if a complete revision were not undertaken.
Many of the service income cases involve a potential §482
adjustment, but the subjective judgments which must be made
under the regulations are difficult and time consuming. Also,
the treatment of the transfer of intangibles in the service
business context is not clearly addressed.

It may well be that the service income situation can be
best remedied by statutory enactment. However, in addition
to, or as an alternative to, legislative changes, a regulations
project could be established to determine whether the §482
regulations could be revised to develop clearer standards,
particularly for allocating income attributable to "know
how" and other intangibles used by a tax haven subsidiary
performing services abroad.

3. Subpart F Regulations

The subpart F regulations should be reviewed with a
view toward eliminating, where possible, the need for subjective
judgments. The subpart F regulations, as in the case of the
§482 regulations, often require that subjective judgments be
made to determine whether a transaction falls v;ithin the
ambit of subpart F. This is particularly true of the regulations
which interpret the foreign base company service income
provisions. For example, the regulations require that in
order for foreiqn base company service income to be generated,
substantial assistance contributing to performance of services
by a controlled foreign corporation must be furnished by a
related person or persons. The determination of whether
substantial assistance is furnished is based on a mathematical
formula, or on a facts and circumstances test. The facts
and circumstances test, which it appears that revenue agents
most often have to rely on, is unclear, and few guidelines
are given in the regulations. It would be useful to at
least provide additional guidelines as to when substantial
assistance is deemed to occur.

133

4. Application of §269 and the Accumulated Earnings Tax

The IRS should determine the extent to which §269 and
the accumulated earnings tax can be applied to tax haven
transactions, and should publish a series of rulings showing
cases in which §269 or the accumulated earnings tax will be
applied to tax haven transactions.

The foreign taxation area is extremely difficult to
administer. The audit of some of the more abusive transactions,
or transactions which threaten the U.S. tax base, might
require that a new approach be tried. One of these would be
to apply §269 more vigorously. The extent to which §269
would apply in the foreign area has not been adequately

explored. For example, in Chapter V there is described a »

promotion involving an offshore commodity company which has •

an offshore parent, the stock of which is owned by U.S. i

persons. The subsidiary distributes its earnings to its j

parent in order to avoid the accumulated earnings tax. This j

transaction might be attacked by applying §269 to disregard ,

the subsidiary. Then, unless the parent distributed its '

income to its shareholders, the accumulated earnings tax I

would apply to the U.S. source income of the parent. Other )

instances abound where these provisions might be applied. }

Arguably, both provisions are ideally suited to deal j

with tax haven transactions. Section 269 on its face is .

intended to apply where the principal purpose of an acquisi- I

tion is avoidance of U.S. tax. By definition, tax haven I

entities are often formed for just such a purpose. «

4
<

5. Rev iew R ev. Rul. 54-140 )

11/ 1

Revenue Ruling 54-140— ^ held, in effect, that a distri- '

bution of stock in a subsidiary corporation v/as a dividend, ]

and established a brother-sister relationship between the «

two corporations. This result has been applied in the case

of pairing of stock in Rev. Rul. 80-213. — ' Accordingly,

abusive decontrol of foreign corporations can take place. (See

discussion at chapter V. D. re "paired" or "stapled" stock.)

— / 1954-1 C.B. 116.
— / 1980-28 I.R.B. 7.

134

The IRS should reevaluate its position in Rev. Rul. 54-
116. Although the IRS has stated its position, the cases
are not clear— ^, and the result of the ruling in the
foreign area has been some avoidance of U.S. anti-abuse
provisions.

6. Revocation of Acquiescence in CCA, Inc.

The IRS should consider revoking its acquiescence in
CCA, Inc. V. Commissioner — , in which the Tax Court held
that a foreign corporation, fifty percent of the voting
rights of which were held by U.S. shareholders and fifty
percent of the voting rights of which were held by non-U.S.
shareholders, was not a controlled foreign corporation. It
is questionable whether the powers held by the foreign
persons in this case were significantly different than the
powers of the foreign shareholders in the cases that the IRS
won in this area. Considering the potential for abuse, the
acquiescence should be revoked.

7. Captive Insurance Companies

The IRS has published a ruling and won a Tax Court case
on this issue. Nevertheless, there is significant activity.
Taxpayers are attempting to have their captives write small
amounts of unrelated risk to avoid "captive" status.

The IRS might consider publishing a ruling stating that
a captive can be fragmented for purposes of determining
whether premiums are deductible. Under this approach, there
would be no shifting or spreading of risk, and hence premiums
would not be deductible, if the premiums paid to the captive
by affiliates exceeded a certain percentage of gross premiums
received by the captive during a year.

8. Income of Foreign Banks

As described in Chapter V, foreign banks doing business
in the U.S. can avoid U.S. tax by booking loans at a tax
haven branch.

— / See DeCoppet v. Helvering, 108 F. 2d 787 (2d Cir.

1940), Wilkinson v. Commissioner , 29 T.C. 421 (1957),
nonacq. 1960-1 C.B. 7. Cf. Spreckels-Rosekrans Investment
Co. V. Lewis , 146 F. 2d 982 (9th Cir. 1945).

— / 64 T.C. 137 (1975), acq. 1976-2 C.B. 1.

135

The problem can be viewed as a regulatory problem, as
a treaty problem, or as an audit problem. The regulations
could be amended to provide that income from a loan negotiated
in the U.S. will be effectively connected regardless of
where booked. In the alternative, the Code could be amended
to give the taxpayer an irrevocable election to treat the
income as effectively connected or not. If the taxpayer
treats the income as not effectively connected with a U.S.
business, it would also have to waive any treaty benefit
otherwise applicable to the interest payment. The audit
problem is one of access to books and records. This could
in part be solved by restructuring transactions in cases where
taxpayers do not supply the necessary records, and putting
the banks to their burden of proof.

t

B. Options Requiring Legislation |

I

The study has shown a significant and growing level of
tax haven use. Transactions which are attempts to evade
U.S. taxes, including transactions to hide narcotics earnings,

appear to be important elements, although legal use is i

probably much greater. The legal use, particularly use by [

multinational corporations, includes many transactions which |

involve drains on what would otherwise be U.S. source income. ■

The IRS has great difficulty in administering the current (

rules. The levels of use and the potential for eroding the I

U.S. tax base, as well as the administrative problems caused ,

by current law, are significant enough to warrant considera- i
tion of changes in the way in which the U.S. taxes tax haven

income. '

t

1. Expansion of Subpart F to Target it on Tax Haven Entities {

Subpart F could be amended by adding a provision which 1

would tax all of the tax haven income of a controlled foreign .

corporation. This could be accomplished by providing that 3

subpart F income would include the income of a controlled J

foreign corporation formed in a tax haven, resident in a tax
haven, or managed and controlled in a tax haven. In the
alternative, the provision could be drafted to treat as
subpart F income that income of a controlled foreign corporation
which is not taxed above some minimal level by the country
where the corporation is formed.

The addition of a targeted approach would be an improve-
ment over the present system from an administrative point of
view. It would provide a clearer focus than the current
lav/ and would eliminate many of difficult technical issues
encountered in tax haven transactions, and accordingly might
discourage some abusive tax haven use.

136

A targeted approach would require that the term "tax
haven" be defined. The Secretary of the Treasury could be
authorized to designate the countries considered tax havens.
In general, a tax haven might be defined as any country in
which the tax burden on all income or on particular categories
of income is substantially lower than the U.S. tax rate on
that income. Countries designated as tax havens would thus
include countries (1) with low tax rates on all income; (2)
with low tax rates on income from foreign sources; (3) with
low tax rates on income from specific types of business; or
(4) which grant low rates of taxation to companies engaged
in "offshore business". A country with a low tax rate would
generally be one which imposes a rate of tax which is one
half or less than one half of the U.S. coryorrate tax rate.
While targeting jurisdictions can present some difficult
problems, Japan, France, and Australia have done so.

Some flexibility could be given to the Secretary by
making the standards "guidelines," rather than fixed objective
classification rules. Thus, the Secretary could take into
account such factors as the existence of a tax treaty between
the U.S. and the other country in determining whether or not
to classify the country as a tax haven. The availability or
nonavailability of commercial or bank information, however,
should not be a factor, as this system would focus more on
legal use than on determinations as to whether a country is
an abusive tax haven.

An exclusion from U.S. taxation could be provided for
income earned by a corporation: (1) that has a physical
facility in its country of residence which is necessary for
its business activities in that country; (2) that is managed
and controlled locally, and which is engaged in its principal
business activity, principally with unrelated parties, in
the country of residence; and (3) that does not receive
greater than a fixed percentage of its gross revenues in the
form of holding company type income (say five percent).

While this option could subject some high taxed non-tax
haven income to U.S. tax, a foreign tax credit would be
available to offset any U.S. tax imposed on that income.

This option does not address the so called "runaway
plants", which are manufacturing operations established by
U.S. companies in countries offering tax incentives to
attract labor intensive investment. Those cases present
issues not addressed by this report.

137

As an alternative to amending subpart F to add a new
category of subpart F income as described above, subpart F
could be changed by narrowing its scope so that it would be
targeted exclusively on tax havens. A problem with this
approach is that non-tax havens can, at times, be used in
ways similar to tax havens. Thus, it might be wiser to
expand subpart F rather than simply to replace it with a
narrower provision.

If a decision is made to target subpart F, the issue
must be addressed of whether to permit taxes paid high tax
countries to offset U.S. tax on tax haven income. Under
present rules, the foreign tax credit limitation prevents
U.S. taxpayers from crediting foreign taxes against U.S.

taxes imposed on U.S. source income. The limitation is i

generally computed on an overall worldwide basis, with I

separate "baskets", however, for certain kinds of income, I

including oil-related income and certain interest income.
Excess credits from one country can be used to offset U.S.
tax imposed on income from another country. At times,

taxpayers attempt to convert U.S. source income to subpart F '

income (which changes its source to foreign) in order to i

absorb excess tax credits. This leaves some continued j

incentive to use tax havens. If subpart F is amended to j

include a provision targeted at tax havens, without any [

change in the foreign tax credit limitation, the same j

planning opportunities would be available. i

One alternative is to adopt a per-country limitation on .

the foreign tax credit, under which taxes paid to each

country are in separate baskets. This method has been used ]

before, and at one time was an optional alternative to the '

overall limitation. It is, however, difficult to administer. '

Transfer pricing and allocation of deductions between all j

foreign affiliates, not only between the U.S. and foreign j

affiliates, would have to be scrutinized. i

«

An alternative would be to create two baskets for
foreign taxes, a high tax basket and a low tax basket.
Taxes paid to all high tax countries would be averaged
together, and taxes paid to all low tax countries would be
averaged together. Therefore, the excess credits from high
tax countries would not offset U.S. tax on tax haven income.
While some administrative problems would exist because of
the need to allocate income and deductions between the two
baskets, the problems would be fewer than those involved
with a per-country limitation.

138

2. Adoption of a Management and Control Test for Asserting
united States Taxing Jurisdiction Over Foreign Corporations

Consideration should be given to expanding U.S. taxing
jurisdiction over corporations to include foreign corporations
which are managed and controlled in the United States.
Today, the United States asserts worldwide taxing jurisdiction
over a domestic corporation, which is defined as a corporation
created or organized in the United States. — ' A foreign
corporation is taxed only on its U.S. source income and
foreign source income which is effectively connected with a
U.S. business.

Often, tax haven corporations conduct substantial
business overseas but are in reality managed in the United
States. That is, all significant policy decisions, as well
as some day-to-day management decisions, are made by employees
of the U.S. parent corporation. Significant administrative
support may also be provided. In some cases, the tax haven
corporation has, at most, a few clerical support employees
located in the tax haven.

In some cases, existing law would permit the United
States to tax at least a portion of the earnings of the
foreign corporation. For example, at times the IRS may
argue that the foreign corporation is doing business in the
United States. In other cases, it may be possible for the
IRS to apply §482 to allocate income from the tax haven
corporation to the U.S. Neither of these approaches is
completely adequate. Prevailing in the trade or business
argument only subjects the corporation's U.S. source income
and its foreign source effectively connected income to United
States tax, whereas U.S. source income would generally be
taxed by the United States in any event. Section 482 can be
extremely difficult to apply from an administrative point of
view. Developing the necessary facts can be time consuming,
particularly when the foreign corporation is located in a
tax haven which restricts access to books and records.

The management and control test for asserting taxing
jurisdiction over a corporation is used in many countries,
including the United Kingdom and its former colonies. This

— / §7701 (a)(4); Treas. Reg. §301.7701-5.

139

test does have limitations as the sole test of taxing
jurisdiction because of the subjective judgments which
often must be made. As an addition to the present rule,
however, it would provide the IRS with an additional means
of scrutinizing many tax haven operations. At times it
would be easier to apply than § 482.

Canada applies a dual test (having adopted the incor-
poration test as an addition to the management and control
test), and has found it useful in dealing with international
taxation problems.

3. Change in Control Test

A number of cases involve attempts to decontrol tax j

haven corporations to avoid subpart F and U.S. reporting I

obligations. While case law supports the view that actual i

control, even without actual stock ownership control, leads
to controlled status, it can be very difficult for the IRS
to establish the fact of control, particularly where the
corporation and the other owners are in a tax haven. At
times, side agreements are suspected but their existence is
difficult, if not impossible, to prove. There are other
control problems, including pairing of stock, which could
become significant if action is not taken. Furthermore, the
10 percent threshhold requirement for U.S. shareholder
status permits distortions and unequitable treatment of
taxpayers in some cases.

Consideration might be given to reducing the percentage
ownership test for controlled foreign corporations status to
a 50 percent test, and to adding a value test as an alter-
native test, as well as to reducing to one percent the level
of stock ownershippfor determining when a U.S. person is a
U.S. shareholder. — ' Adoption of these rules would permit
U.S. taxation of the growing number of 50/50 joint ventures,
and would eliminate avoidance of U.S. tax through the pairing
of stock. It would also provide some equity as between U.S.
persons who own 10 percent of the stock and those who do
not. Consideration might also be given to dropping the
controlled threshhold down to 25 percent, as was done in the
case of U.S. insurance of U.S. risks for subpart F purposes,
and as the French have done in their tax haven legislation.
A drop in the threshhold could apply only to corporations
formed in tax havens.

18/

The Senate version of the Tax Reduction Act of 1975
contained a provision which would have redefined the
term "U.S. shareholder" to include a U.S. person holding
a one percent or greater interest in a foreign corporation.
See H. Rep. No. 94-120, 94th Cong., 1st Sess. 69-70
1975-1 C.B. 631.

140

At the very least, the "paired" or "stapled" stock
problems should be addressed. One option is to amend the
Code to treat stock of a corporation which is paired with
stock of a second corporation as owned by the second
corporation. Such a provision would also curtail avoidance
of the anti-boycott and DISC provisions through pairing.

4. Service and Construction Income

The service and construction industries are significant
users of tax havens, and present the IRS with unique problems.
Many of the problems appear to involve the transfer of a
U.S. business to an offshore subsidiary, and include the
transfer of know-how or goodwill from the U.S. parent to the
tax haven affiliate. There also seem to be significant
situations involving, for example, the negotiation of contracts
in the U.S., their signature by officers of the foreign
affiliate who may also be officers or employees of the U.S.
parent follow by the transfer of know-how without any com-
pensation. Many of these cases might result in subpart F
income or §482 allocations to the parent if identified and
fully developed by the IRS. Considering the limitations of
resources, however, identifying these cases and fully de-
veloping them is extremely difficult. Moreover, the foreign
subsidiaries are routinely established in tax havens having
commercial secrecy, which present the IRS with additional
books and records problems.

A narrow approach to dealing solely with services
income would be to add a branch rule to the foreign base
company services income provisions. A branch rule {which is
contained in the subpart F sales provisions) could provide
that foreign base company services income would include the
income attributable to the carrying on of service activities
of a branch of the controlled foreign corporation, by treating
the income as derived by a wholly owned subsidiary of the
controlled foreign corporation. Thus, if a tax haven company
is performing services in a third country through a branch,
and the direction for or support of those services is provided
by the tax haven company's home office, or by employees of
that office, the income would be foreign base company services
income. An alternative approach, and one which would be far
simpler to administer, would be to treat all income from the
performance of services outside of the country of incor-
poration of the controlled foreign corporation as subpart F
income.

141

Two serious issues which must be addressed in the service
and construction cases are whether the tax treatment of
these businesses should be left alone for competitive reasons
and whether we can afford to continue to export this kind
of technology without exacting a U.S. tax.

5. Merger of the Foreign Personal Holding Company Provisions
into Subpart F

Consideration should be given to eliminating the foreign
personal holding company provisions and incorporating their
substance into subpart F.

Today, foreign personal holding company income may be
taxed under either the foreign personal holding company
provisions — or under subpart F. If both provisions apply
to a particular foreign corporation, then the foreign
personal holding company provisions will apply and not
subpart F. — ' Accordingly, it may^be possible to avoid the
investment in U.S. property rules — of subpart F by causing
a foreign corporation to be a foreign personal holding company
and to earn a small amount of foreign personal holding
company income in a year in , which a significant investment
in U.S. property is made. —

1^/ §§551 through 558.
20/ §951(d).
21/ §956.

22/ See Estate of iDvett, 1980-1 USTC 9432; contra. Estate
of Whitlock V. Commissioner, 494 F. 2d 1297 (10th Cir.
1974), rev'g 59 T.C. 501 (1972), cert, denied, 419 U.S,
839 (1974), reh'g denied 419 U.S. 1041 (1974).

Further, the foreign personal holding company attribu- |

tion rules have never been rationalized. The provisions i

contain technical problems. For example, the foreign personal j

holding company attribution rules provide for attribution of .
stock ownership between siblings. In addition, they require

attribution from a foreign individual to a U.S. individual. J

Accordingly, the acquisition by a U.S. person of a small '
amount of stock of a foreign corporation, in which his

sister (who is a foreign resident) owns 50 percent of the j

stock, could make that corporation a foreign personal holding j

company and subject that person to tax. Attribution occurs J

even without actual ownership of stock by the individual. <
A U.S. person may thus have a technical obligation to file a

142

return with respect to the foreign company, even though he
owns no stock and may not be able to get any of the details
needed to complete a return. The IRS has lost a case on
this issue. — '

Moreover, the foreign personal holding company pro-
visions do not contain proper anti-double counting rules
similar to those in §959.

Finally, it appears that few foreign personal holding
company returns are audited. If foreign personal holding
company issues are raised, they generally will be addressed
by agents who are not trained in those issues. Because
international examiners concentrate on large cases, they
have not developed practical audit experience in the foreign
personal holding company area.

The structure of taxing foreign corporations controlled
by U.S. persons would be simplified by repealing the foreign
personal holding company provisions, and incorporating their
substance into subpart F. Some technical changes, including
a change in the subpart F stock ownership test, might be
made.

In the alternative, §951 (d) could be amended to over-
ride the Lovett case. This could be accomplished by pro-
viding that a U.S. shareholder who is subject to tax under
§551(b) on income of a controlled foreign corporation for
his taxable year, which is also a controlled foreign
corporation, will be required to include in gross income,
for that taxable year, any amount with respect to that
controlled foreign corporation invested in U.S. property,
to the extent of its earnings and profits, but the amount so
included will be reduced by the amount included under §551.
The foreign personal holding company attribution rules could
be amended to incorporate the §958 rules.

These changes would at least eliminate the loophole
created by the lovett case, and would rationalize the foreign
personal holding company provisions somewhat. They would,
however, still maintain two parallel and possibly overlapping
systems with all of the attendant administrative problems.

23 / See Estate of Nettie S. Miller v. Commissioner, 43 T. C.
760 (1965), non acq. 1966-2 C.B. 8.

143

6. Captive Insurance

Despite IRS rulings and a successful court case, captive
insurance companies continue to proliferate in the tax
havens. In f^g^/ aggressive planning is attempting to avoid
the case law. — One legislative approach might be to amend
subpart F to extend its coverage to include the premiums
received by a controlled foreign corporation for insuring
foreign risks of related persons. This approach would be
consistent with the base company concept found in the foreign
base company sales and services income provisions. Another
approach might be to clarify the application of the foreign
base company services income provisions to insurance of
risks of related parties.

7. Shipping Income

The use of tax havens to shelter income from shipping ,

has been considered by the Congress. As originally provided, I

shipping income was excluded from subpart F. In 1975, |
subpart F was amended to include shipping income, but earnings

reinvested in the shipping business were excluded. The IRS i

has had little audit experience with these provisions to j

date, but they are technically complex and may require some i

on-site audits, which as a practical matter may be impossible j

to do. For administrative reasons, consideration might be •

given to taxing shipping income directly. I

8. De minimis Exclusion from Foreign Base Company Income

The de minimis exclusion from foreign base company ^

income could be amended to add an alternative dollar limitation. •

Today, if foreign base company income of a controlled j

foreign corporation is less than 10 percent of its gross '

income, none of its gross income is taxable as foreign base j

company income. By using this exception, larger companies ,

can shelter significant amounts of passive income. — This •

shelter could be removed by adding an alternative dollar
limitation, so that the exception would not apply if the
controlled foreign corporation's foreign base company income
exceeds a fixed dollar amount.

9. Commodity Shelters

One solution to the use of tax havens as situs for
alleged commodity shelter transactions would be to deal
directly on a technical basis with tax straddles. The Code

24 / See discussion at Chapter V. C.6.
25/ See discussion at Chapter v. C.2.

144

could be amended by adopting a provision which would (1)
postpone recognition of losses from certain straddle positions
during the period in which the taxpayer holds offsetting
positions plus the following 30 days, and (2) suspend the
running of the holding periods (of the assets comprising the
offsetting positions) during the balance, plus the following
30 days. In addition, §1221(5) (denying capital asset
treatment to certain government obligations) could be repealed.

Tax straddles are a significant and growing problem.
They are motivated solely by tax considerations, and offer
no opportunity for meaningful economic return. As explained
in Chapter V, a tax haven situs is often used as the alleged
situs for the transaction in order to obfuscate the audit
trail. Significant amounts of audit time, as well as crowded
court calendars, can make it difficult to deal with these
cases under current law. Tax straddles are an even more
significant problem domestically.

Most often the straddle shelters are used to defer
income by producing paper losses in one year while deferring
the offsetting gains to a later year. They may also be used
in an attempt to convert short term gain into long term gain
or capital losses into ordinary losses. These straddles
have been structured primarily in commodities, including
metals, and in government securities.

The above proposal would deal directly with the problem
by denying the benefits of the tax straddle. While it could
be developed solely in terms of tax haven transactions, the
scope of the problem would require that any legislation
considered should also cover domestic tax straddle transactions.

10. Tax Haven Deductions

Another more general approach to tax haven related
shelters, and to the overall problem of phoney tax haven
related deductions, would be to amend the Code to specifically
disallow a deduction for amounts paid or accrued to a tax
haven person or entity, unless the taxpayer establishes by
clear and convincing evidence that the underlying trans-
action occurred and that the amount of the deduction is
reasonable. While this in essence is the current law, a
clear rule targeted at tax havens would help to speed up the
administration of the law. A similar rule, requiring a
taxpayer to produce documentary evidence as to the value of
offshore property, would also be useful. This would require
that the taxpayer give to the IRS written material which IRS
engineers can evaluate without having to visit the property.

145

Additional reporting of tax haven transactions would
also be helpful. A major problem today is identifying haven
transactions so that they can be audited. Consideration
should be given to reporting of any transaction with a
foreign person, as well as any investment in foreign property.
In addition to the existing criminal and civil penalties for
non-filing which would apply in this case, the penalty for
failure to provide the information could include denying any
deductions relating to the unreported foreign transaction.

11. No Fault Penalty

Consideration should be given to adopting a no fault
penalty on the order of 50 percent of a substantial tax
haven related tax deficiency.

Today, taxpayers often enter into questionable tax 1

haven transactions, taking the calculated risk that they '

will not be identified. Even if the taxpayer is identified, j

a number of years can pass before the tax plus interest is j

actually paid. During this time the taxpayer has the use of '

the money, the effect being a loan from the Treasury. '

A no fault penalty would place the taxpayer under some
risk and would go a long way toward curbing abusive shelter
and other deduction generating transactions.

12. Foreign Trusts

Most non-fraudulent use of foreign trusts by U.S. .

persons appears to have been eliminated. However, some

schemes have developed to take advantage of perceived loopholes. \

For example, the sale or exchange exception from §679 is '

allegedly being abused. To curb this abuse, the exception '

could be eliminated. In the alternative, the provision !

could be eliminated only in the case of transactions with a j

trust which has as a party in interest a person related '

to the transferor. The sale or exchange exception is often i

met, by a long-term installment sale. This scheme could be
eliminated either by eliminating the sale or exchange exception
or by providing that an installment sale will not be considered
a sale or exchange to a foreign trust if the note runs for
more than a set period of years, such as five years.

The use of foreign trusts by foreiqn persons who later
become U.S. residents could be minimized by providing that a
tranferor will be taxed on the income from property transferred
to a foreign trust if the transfer takes place within a
fixed period of time before the transferor becomes a U.S.
resident. This is a jurisdictional problem and any change
requires a major policy decision as to the point at which
the U.S. should assert taxing jurisdiction.

146

The foreign trust rules do not apply to a transfer by
reason of the death of the transferor. To limit the estate
planning opportunities exceptions for testamentary transfers
could be removed. The income would have to be taxed to the
beneficiaries, however. Technical changes, such as elimi-
nating §679 from the scope of a §1057 election, and changing
the definition of a U.S. beneficiary so that a foreign
corporation is considered a U.S. beneficiary if more than 10
percent of its stock is owned directly or indirectly by
foreign persons, could be made.

13. Expatriation

U.S. persons who seek to expatriate often expatriate to
a tax haven. The current rules covering expatriates are
complicated and at times difficult to administer. They
could be improved and made easier to administer by sub-
jecting the expatriate to tax on the difference between the
fair market value of his property at the date of expatriation
and his basis in the property. In this way the tax, including
the tax on foreign property, would be paid upon expatriation
and the expatriate could then be treated as any other non-
resident alien person. Canada has a similar system. A
similar rule could be adopted for the departure of resident
aliens, although such a change would represent a greater
deviation from present policy than the change suggested for
expatriates.

14. Residence

A clear objective rule for determining when an alien
becomes a U.S. resident might be adopted. Today, the rules
as to when an alien becomes a resident are subjective and
are difficult to administer. It might be better to adopt
a clear rule for determining residence, for example, 183
days in the U.S. during a year. While such a rule is sub-
ject to manipulation, so is the present rule, and certainty
might be preferable.

147

VIII. Treaties With Tax Havens

Tax treaties modify domestic tax law to reduce tax
otherwise imposed on foreign investment in the treaty countries.
Treaties with tax havens are often used by residents of non-
treaty countries to achieve a reduction in United States taxes.
Although most of this use is not fraudulent, some is abusive
and inconsistent with present United States tax policy. The
low rates of tax coupled with the anonymity afforded by tax
havens do, however, give rise to some fraudulent use.

United States taxpayers, particularly multinational
corporations, may also use the United States treaty network
and tax havens to advantage. The most widely known use is
that of Netherlands Antilles finance subsidiaries to achieve
zero rates of tax on interest paid on foreign borrowings.
Often, the advantages which can be achieved through tax
haven treaties can also be achieved through treaties with
non-tax havens.

A. Basic Principles

Tax treaties are often referred to as conventions to
eliminate double taxation and avoid fiscal evasion. Double
taxation can arise in the case of a United States taxpayer,
because the income earned by him may be taxed by both the
United States and, if earned in another country, by that
country as well. The United States unilaterally attempts to
mitigate this double taxation by permitting a tax credit for
income taxes paid to foreign countries. However, because of
differences in source rules between the United States and
the other country, and because of problems of defining when
a foreign tax is an income tax for purposes of the United States
foreign tax credit, there may still be some cases of significant
double taxation.—

1/ It can be argued that the real impact of treaties >

is to eliminate excess taxation. The unilateral relief
afforded by the United States probably works well in most
cases. However, rates of tax in the other country may
exceed United States rates, particularly when withholding
taxes on distributions are taken into account. Reduction
of these taxes leads to elimination of excess taxation
rather than double taxation.

148

Under United States law, passive income paid to foreigners
not doing business in the United States is taxed„at a rate
of 30 percent of the gross amount of the income.— United
States income tax treaties reduce this rate of tax in the
case of payments to residents of a treaty country. The
United States position, as reflected in the United States
Model Income Tax Treaty, is that the rate of tax on dividends
should be reduced to five percent in the case of direct
investment (ownership of 10 percent or more of the stock of
the payor corporation) and to 1 5 percent in the case of
portfolio investment. Interest and royalties should be
exempt from tax at source. The OECD Model contains similar
rules for dividends and royalties, but permits a 10 percent
tax on interest at source.

While treaty benefits are theoretically intended to
inure to residents of each of the treaty countries, third
country residents often seek to take advantage of them. At
times, this use by third country residents may coincide with
perceived United States interests; at other times, however,
this use may be abusive. The treaties therefore generally
contain some provisions designed to limit the benefits of
the treaty to residents of either of the two contracting
countries. However, "resident" is broadly defined as any
person who under the laws of a country is liable for tax by
reason of his domicile, residence, citizenship, place of
management, place of incorporation, or other criterion of a
similar nature. Persons taxable in a country only on
income from sources in that country , or on capital situated
in that country are not residents.— Interest and royalties
are covered at source only if both "derived and beneficially
owned by" a resident of the other country.

The United States Model and some of the treaties in
force contain an anti-holding company provision which denies
the reduced rate of tax on dividends, interest, and royalties
(1) if the recipient corporation is a resident of the other
country which is at least 25 percent owned, directly or
indirectly, by individual residents of a country other than
the country of residence of the corporation, and (2) if
special tax measures apply in the country of residence which

2/ §§871 and 881.

3/ Article 4, U.S. and OECD Models.

149

reduce, substantially below the generally applicable corporate
tax rates, that country's tax imposed on dividends, interest,
and royalty income from sources outside that country.-'^

Variations on the Model article are found in other
treaties. In the proposed Cyprus treaty, denial of reduc-
tion of tax at source is applicable if either (1) the tax
burden in the country of residence of the corporation on the
income is substantially less than the tax generally applied
in that country on corporate profits, or (2) 25 percent or
more of the stock of the recipient corporation is owned by
individuals not resident in that country.

B. Tax Haven Treaty Network

The United States has over thirty income tax treaties
in force. Most are with developed countries which are
significant trading partners. However, the United States does
have treaties in force with at least 15 jurisdictions generally
considered to be tax havens to some degree. In addition,
the United States has an income tax treaty with the Netherlands,
generally considered a tax haven by reason of its treaty
network and its special holding company legislation. For
purposes of this chapter, the Netherlands will be considered
to be a tax haven.

Most tax haven treaties are in force as a result of the
extension of the old 1945 United States-United Kingdom
Income Tax Treaty to the former United Kingdom colonies.
That treaty provided for its extension to overseas territories
of the United Kingdom. The United Kingdom requested that
extension, and the Senate gave advice and consent to ratification
of the extensions in 1958. The extensions became fully
effective in 1959. I

I

Likewise, the treaty with the Netherlands Antilles is
in force as a result of the extension of the United States-
Netherlands Income Tax Treaty of 1948, as amended. The
treaty provided for extension to overseas territories of the
Netherlands. This extension was effective to the Netherlands
Antilles in 1955. The Netherlands Antilles adjusted its
internal law to take advantage of the treaty by providing

4/ Article 4, United States and OECD Models. Similar
provisions are contained in United States treaties
with Finland, Iceland, Korea, Luxembourg, Norway, Trinidad
and Tobago, and the United Kingdom. A limited
anti-avoidance provision applicable only to direct
investment dividends is contained in the Netherlands
Antilles treaty.

150

for special tax regimes for certain local holding companies.
Generally, such companies were taxed at rates ranging between
2.4 and 3.0 percent. This made the Netherlands Antilles an
attractive vehicle to residents of third countries who
wanted to invest in the united States. A 1963 protocol,
effective in 1967, reduced or eliminated some of the benefits
of the Antilles treaty which were formerly available, but
other benefits remained.

The United States also has tax haven treaties which
were directly negotiated with Luxembourg, the Netherlands,
and Switzerland. The Luxembourg treaty was signed in 1962
and came into force in 1964. The Swiss treaty was signed in
1951 and entered into force in that year. The treaty with
the Netherlands was originally entered into in 1948, and has
|! been amended from time to time, most recently by a 1965
t' protocol which became fully effective in 1967. The United
[' States has recently signed an income tax treaty with Cyprus,
j a recognized tax haven.—

There does not seem to have been much, if any, consid-
eration of either potential abuse in the negotiation of the
existing tax haven treaties, or of whether to permit extension
of treaties to the territories of our treaty partners.
Currently, efforts are under way to deal with the problems
created by the Swiss and Netherlands treaties, as well as
the Netherlands Antilles and British Virgin Islands treaties.
In addition, abuse of treaties was addressed in the Cyprus
treaty, which contains a number of anti-avoidance provisions.

The data in tables 1 and 2, to this chapter, indicate
that there is significant use of treaty countries in general,
and tax haven treaties in particular for investment in the
United States. Much of this use must be by nonresidents of
the treaty country, because the volume of investment does
not bear any relationship to the indigenous populations of
those countries. In 1978, $3.9 billion out of a total of
$4.5 billion, or 89 percent, of gross income paid to nonresidents
of the United States was paid to treaty countries. Of that
amount, $1.8 billion out of the total $4.5 billion of gross
income paid to nonresidents of the United States went to
treaty countries which are also tax havens. In that same
year, $309 million or 31 percent of the interest paid to
nonresidents went to tax haven treaty countries, and $1.4

5^/ M. Langer , Practical International Tax Planning , 278, 279
(2d ed. 1979) B. Spitz, Tax Havens Encyclopaedia , (1975).

151

billion or 48 percent
haven treaty countries
Switzerland is clearly
one-third of the divid
of the United States,
interest, went to Swit
Netherlands Antilles a
passive income from th
of the Netherlands rec
the dividends, and 3.6
paid to nonresidents,
with a population of o
the total United State
13 percent of the inte
dividends. These thre
approximately 40 perce
more than 48 percent o
interest. None of the
gross terms, although
British Virgin Islands
million in 1975 to $8
the gross payment in 1

of the dividends paid went to tax
On a country by country basis,

the most widely used. In 1978, over
ends ($985 million) paid to nonresidents
and 14 percent ($135 million) of the
zerland. The Netherlands and the
Iso received significant amounts of
e United States. In 1978, residents
eived 12 percent ($331.7 million) of

percent ($35.5 million) of the interest

Residents of the Antilles, a country
nly 230,000, received four percent of
s payments to foreigners, comprised of
rest and almost two percent of the
e countries together accounted for
nt of all payments made to foreigners;
f the dividends and 30 percent of the

other tax havens is significant in
total payments to "residents" of the

have grown from approximately $1
million in 1978, with about two-thirds of
978 consisting of dividends.

It is interesting to note that the number of British
Virgin Island companies in which United States persons have
an interest grew from 53 in 1970 to 678 in 1979. The number
of BVI companies in which United States persons own more
than 95 percent of the stock increased over the same period
from 40 to 316.

Despite the obvious abuse of the treaties, a large and
growing network of treaties, and an aggressive treaty nego-
tiation program, existing treaties are not reviewed on any
systematic regular basis, and the United States has shown
little inclination to terminate them. Consequently, treaties
which perhaps can be abused or which no longer serve a
legitimate economic purpose are still in effect. Further,
the United States has been slow to take action to deal with
changes in the domestic laws of its treaty partners.

Barbados amended its tax laws some years ago to provide
for favorable tax treatment for international business
companies.—'^ The United Kingdom quickly dealt with the
problem by insisting that the United Kingdom-Barbados Income
Tax Treaty be revised to exclude international business

6/ Barbados International Companies Act of 1965 (No. 50 of
1965, as amended by No. 60 of 1977).

152

7/
companies.— The United States has never taken steps to

deal with Barbados. Another of our treaty partners, St.

Vincent, has become a center for "captive banks," that have

been used to perpetrate some significant frauds upon United

States banks and that allegedly have been used„by aggressive

tax planners in an attempt to avoid subpart F.— The efforts

of the British Virgin Islands to adapt its law to the United

States-British Virgin Islands Income Tax Treaty are set out

in a detailed article in the Tax Law Review.—^

C. Third Country Resident Use of United States Tax Treaties
with Tax Havens

Most of the transactions described below are permitted

by the literal language of the Code and the treaties. These

transactions are permissible because of a conflict between
two inconsistent policy objectives:

(1) Encouraging foreign investment in the United States
and the free flow of international trade and capital;

(2) Not treating foreign investment in the United States
differently from investment by United States persons,
and not providing incentives to foreign investment by
united States companies.

Any attempt to tax some of the transactions must also
attempt to reconcile this conflict. In addition, foreign
policy considerations as well as international trade policy
considerations must be taken into account.

1. Forms of Third Country Use

Each of the following hypothetical transactions is
based on a number of actual cases that either have been
described to us or have been the subject of a ruling or a
court case. Many of these transactions are permitted by the
treaty language. Some reflect policy decisions of the

Ij See Article XXIII U. K. -Barbados Income Tax Convention.

See M. Edwards-Ker, The International Tax Treaties Service ,
Article 4, page 46.

V See Chapter V. C.2.

9^/ Vogel, Bernstein, and Nitsche, "Inward Investment in
Securities and Direct Operations Through the British
Virgin Islands: How Serious a Rival to the Netherlands
Antilles Island of Paradise?", 34 Tax L. Rev. 321 (1979).

153

treaty negotiators. The tax consequences of some transactions
would be changed if detected, however, detection is difficult,
often depending upon the cooperation of the treaty partner.

a. Foreign borrowing . A borrowing by a United States
person is arranged through a treaty jurisdiction to take
advantage of the reduced rate of tax (zero in most cases) on
interest. There are two patterns of borrowing: (1) a
conduit which a United States borrower or foreign lender
forms as an entity in a treaty country for the specific
purpose of funneling a specific loan through it; (2) a
finance company situation in which a United States company
forms a subsidiary in a treaty country and the subsidiary
then sells its obligations to the public overseas.

An abusive example of the conduit case is described in
Aiken Industries, Inc. — ' A United States corporation
borrowed money from its Bahamian parent and issued a promissory
note to the parent. A Honduran company was then formed and
the parent transferred the United States corporation's note
to the Honduran company in exchange for its demand notes
bearing the same rate of interest as the United States corporation's
note. The United States corporation claimed exemption from
its withholding obligation under the then effective IMited
States-Honduras income tax convention, which exempted interest
received by a Honduran corporation from a united States
corporation from United States withholding tax. Although
not stated in the case, presumably interest payments by the
Honduran company to its Bahamian parent were not taxed by
Honduras.

The court held that the exemption did not apply because
the treaty language exempted interest from United States
sources "received by" a Honduran corporation. Under the
facts presented the interest was not received by a Honduran
corporation. The Tax Court interpreted the words "received
by" to mean something more than merely obtaining physical
possession of the funds coupled with an obligation to pass
it on to a third party.

b. Finance companies . Without a treaty, a United States
company which borrows abroad must withhold the statutory 30
percent tax imposed on the interest paid with respect to the
debt. The cost of this tax is born, at least in part, by

the united States borrower in the form of an increased
interest payment to cover the United States tax on the
interest. In an attempt to avoid imposition of this tax,
many borrowers, particularly multinational companies,
establish a subsidiary in the Netherlands Antilles. The
subsidiary then borrows overseas (usually in the eurodollar
market), and relends the borrowed funds to the parent. The

10/ 56 T.C. 925 (1971).

154

position taken by the borrower is that the interest paid by
the parent to the subsidiary is deductible for United States
tax purposes and is exempt from Lfriited States withholding
tax. The payment of interest by the subsidiary to the
foreign lender is also exempt. The Antilles company would
be taxable by the Antilles on the interest it receives, but
the interest it pays out to the ultimate lenders is deductible.
Accordingly, the only tax on the interest payment is the
Antilles tax on the difference between the interest received
and the interest paid out, usually a small amount. That
tax might be a creditable tax for United States purposes.
The Antilles will not impose a withholding tax on the interest
paid by the Antilles company. (Similar results, sometimes
through different arrangements, might be achieved under
other treaties, e.g. ,, British Virgin Islands, Luxembourg,
and the Netherlands. )— ^

c. Holding companies . Another use of tax haven treaties
involves establishing a holding company in a tax haven with
which the United States has a treaty and then arranging to
have the income received from the United States paid out in
a deductible form. One use of a holding company is for so-
called back-to-back or pass through royalties. A foreign
person licensing a patent for use in the United States is
subject to a United States tax of 30 percent of any royalty
received. This tax can be reduced (in some cases to zero)
by forming a Netherlands corporation and licensing the
patent to that corporation. The Dutch corporation would
then license the patent to the United States licensee. The
royalty would be paid to the Dutch company, which will, in
turn, pay it to the owner of the patent in a deductible
form either as a royalty or as interest.

Article IX of the United States-Netherlands income tax
treaty exempts from United States tax "royalties paid to a
resident or corporation of one of the contracting states . . .
Accordingly, taxpayers take the position that the payment of
the patent royalty to the Netherlands company will not incur
any United States tax. The Netherlands company can deduct
the royalty (or interest) paid to its shareholder and the
Netherlands does not impose a tax on a royalty payment.
Thus, the royalties will be paid out to the Netherlands

11 / See , however, Lederman , "The Offshore Finance

Subsidiary: An Analysis of the Current Benefits and
Problems," J. of Tax . 86, (1979), discussing various
possible approaches which the IRS could consider
to deal with finance companies. See , Joint Committee
on Taxation Pamphlet, Description of H. S. 7 553
Relating to Exemptions from U.S. tax for Interest
Paid to Foreign Persons (June 18, 1980).

155

company free of United States tax, the Netherlands company
will incur little or no tax, and the patent owner will pay
no tax (assuming, of course, that he is resident in a country
which does not tax the income, or he has the royalties paid
to a nominee in a second zero tax jurisdiction).

The Netherlands treaty does not have any anti-treaty
shopping provision applicable to this structure. Even if
the treaty contained a provision similar to Article 16 of
the United States Model, the abuse would not be prevented
because, in order for Article 16 to apply to deny treaty
benefits, the income of the Netherlands company must be
subject to a special rate of tax by the Netherlands. Instead
of subjecting the corporation to a special rate of tax, the
regular corporate rates may be applicable, but because the
payment by the Netherlands company is deductible by it, and
because it almost equals the royalty received, there would
be little or no tax due.

The payment of the royalty from the Netherlands company
to the ultimate owner is United States source income subject
to the 30 percent LTnited States tax, because the royalty is
paid for the use of patents in the U.S. — ' A taxpayer might
attempt to avoid this result by having the Netherlands
company pay the royalties in another deductible form such as
interest.

Direct investment in the United States can also be
structured through a holding company. For example, a foreign
company can establish a Netherlands holding company which in
turn forms a wholly owned subsidiary in the United States.
Under the treaty with the Netherlands, dividends paid by the
United States subsidiary (assuming it conducts an active
business) may be taxed by the United States at the rate, of
five percent rather than the 30 percent statutory rate. — '
With proper planning, the Netherlands corporate tax may not
be imposed. Furthermore, if the Dutch company is a subsidiary
of an Antilles company, the Dutch company can then pay
dividends to the Antilles free of tax. The same result is
available by having a corporation resident in the British
Virgin Islands own all of the stock of the United States
corporation .

12 / §861(a)(4). See Rev. Rul. 80-362, 1980-52 I.R.B. 14.

13 / Article VII, United States-Netherlands Income Tax
Convention.

156

d. Active business . A foreign person can engage in an
active United States business by forming a company in an
appropriate tax haven treaty country and having that company
conduct the business. Some treaties waive the tax imposed
on dividends and interest paid by a foreign corporation
which earns most of its income in the United States. — '
Article XII of the United States-Netherlands Income Tax
treaty as extended to the Antilles (the United States-Antilles
treaty), for example, provides that dividends and interest
paid by an Antilles corporation are exempt from United
States tax except where the recipient is a IMited States
person. The Antilles does not impose a tax on dividends

paid by an Antilles company. Accordingly, if an Antilles
company earns most of its income in the Lftiited States no tax
would be paid on its dividend distributions (or payments of
interest by it). A resident of a non-treaty country can,
therefore, establish a corporation in the Antilles to
directly engage in an active business in the United States,
and avoid the 30 percent tax on dividends which would otherwise
be imposed. The same result can be achieved under the
Netherlands treaty by structuring the investment so that the
stock of , the Netherlands company is held by an Antilles
company. —

e. Real estate investment . Another form of tax haven
treaty investment in the United States is the use of a
company formed in the treaty country to invest in United
States real estate. The tax advantage of using a tax haven
for real estate investment has been limited by recently
enacted legislation. This legislation will override existing
treaties, but not until 1985. A non-resident alien individual
or foreign person not engaged in trade or business in the
United States is taxable on the gross amount of rents from
real property at the 30 percent or lower treaty rate.

Before the new legislation is effective for treaty countries,
gain from the sale of the property is not taxed. The
investor could elect to tax the income on a "net basis"
rather than a gross basis. The election applied to gain
from the sale of the property, as well as to rental income
from it. The election could not be revoked except with
consent of the IRS. Under the United States-Antilles treaty,
however, an individual or corporation resident in the
Antilles could make an annual election to have the

lA/ See §861(a) (1) (D) and §861 ( a ) ( 2 ) (B) providing

that dividends and interest paid by corporations are
united States source income.

15 / The second withholding tax is also waived in United

States treaties with Finland, Iceland, Korea, Luxembourg,
Norway, Trinidad and Tobago, and the United Kingdom.

157

income from United States real estate taxed on a net basis.
Accordingly, a foreign investor who purchased real estate
through an Antilles company would usually make the net
election in the years he holds the property in order to be
able to use the deductions generated by it. Then, in the
year he wishes to sell, he could simply not elect to be
taxed on a net basis and avoid Uhited States capital gain
taxes on any gain realized on the sale. Furthermore, amounts
could be paid on the property free of United States tax to
the Antilles company or by the Antilles company to other
foreign persons. The use of an Antilles company by non-
residents of the Antilles to take advantage of this provision
had become standard practice.

f. Personal service companies — artists and athletes . The
provider of an entertainment service enters into an employ-
ment contract with a company formed in a tax haven. The
contract generally provides that the artist will work exclusively
for that company which will have the sole right to contract
his services. In addition, the company has the right to the
proceeds from the sale of artistic works, such as phono-
graph records. The entertainer receives a fixed salary from
the company. The company then enters into a contract with a
promoter who arranges a United States tour for the entertainer.
The entertainer takes the position that the income from the
tour is income of the company. The company does not have a
fixed place of business in the United States and therefore
there is no United States tax. The entertainer's salary may
not be taxed because of the operation of a treaty. Further,
the proceeds from the sale of the phonograph records will be
paid to the tax haven company, and the zero treaty rate of
tax on royalties will be claimed. In some cases, the IRS may
argue that the entertainer has a permanent establishment in
the United States, that the profits from the sale of the
record are effectively connected with it, and that they are
therefore subject to United States tax.

Under Article 17 of the new United States-Uhited Kingdom
treaty and under the United States Model, the income from
the performance of the services would be subject to United
States tax. However, in most cases the expenses related to
a tour are high and thus taxable income is low. The real
purpose of the tours is often to promote records, and the
income from the sales of records can be high. The payments,
however, may be exempt from tax as royalties. They will not
be taxed in the tax haven.

2. Analysis of Third Country Use

The problem created by treaties are third country use,
or treaty shopping, and administration of the treaties.

158

Successful treaty shopping generally consists of three
elements: (1) a reduction of source country taxation; (2) a
low or zero effective rate of tax in the payee treaty country;
and (3) a low or zero rate of tax on payments from the
payee treaty country to the taxpayer. Many of these elements
exist with respect to non-tax haven treaties as well as tax
haven treaties. For example, some non-tax haven countries
with which we have treaties do not impose a withholding tax
on payments of interest or dividends, and accordingly can
be used as the Netherlands or the Antilles is used.

The first element is provided by the treaty reduction
of United States tax on United States source fixed or determinable
income, by the limitation on business income subject to tax,
and by certain exemptions from tax for capital gains and
transportation income.

The second element is provided by a tax haven which may
impose a low rate of tax on income of "residents", or which
may provide a special tax regime for holding companies. It
is also provided by a back-to-back pattern in which the
amounts received by the company in the treaty country are paid
out in a deductible form.

The third element is provided by tax havens, by some
non-tax havens which do not tax distributions, and by
treaties between the payee country and third countries. It
is also provided by United States treaties which eliminate
the second withholding tax imposed by the United States.

The above cases, as well as IRS data, indicate significant
third country use of United States treaties. The data
indicate that our treaties are a substantial funnel for
foreign investment in the United States, particularly through
tax haven countries with whom we have treaties.

The tax burden on a third country treaty user can be
less than that on a non-user, a United States investor or a
resident of the treaty country. This is because in most
cases the United States investor will pay a United States tax
on his return on investment, and the true resident of a
treaty country will pay tax to his home country, while in
the case of a third country user who is avoiding his home
country tax or whose home country does not impose a tax, no
tax will be paid.

Accordingly, our tax haven treaties probably do place United
States businesses in a competitive position to attract
foreign capital. As the above transactions demonstrate,
however, this incentive is often accomplished at the expense
of simplicity and overall equity, by economic structures and

159

business transactions which cannot be justified on business
grounds. In addition, a substantial part of the investment
through tax haven treaties may not be incremental at all.
It may merely be shifted to the most favorable structure
from a tax planning point of view.

In relying on treaties with tax havens to encourage
foreign investment in the United States we also encourage
the use of transactions which have little or no economic
substance. This, in turn, has a negative effect on the
taxpayer's respect for the system. For example, a Netherlands
holding company that licenses patents to United States
persons, or a Barbados international business corporation
which invests in U.S. securities, have little business
purpose other than utilization of the treaties (and perhaps
avoiding local exchange controls). While the United States
arguably benefits in some way by the investment, it does so
at the cost of allowing taxpayers to play fast and loose
with the system, with adverse consequences for overall tax
administration.

The first inquiry therefore is whether, in fact, we
wish to curtail some or all of the above described transactions.
Such a decision requires basic policy analysis and decisions
which are beyond the scope of this report. However, it
should be pointed out that much of what we say we are doing
through treaty policy, that is, encouraging inward invest-
ment, could be done unilaterally through the Code. What
would be lost would be the reciprocal benefits which we can
negotiate; what would be gained would be a clearer, more
rational tax system. Also, the existence of treaty shopping
potential discounts the value of high withholding taxes as a
bargaining chip in treaty negotiations. As long as the
treaty shopping potential exists, there is less pressure on
other treaty countries whose residents invest in the United
States through treaty countries to negotiate with the United
States.

D. Use of Treaty Network by Earners of Illegal Income or
for Evasion of Lftiited States Tax

It is not possible to determine the extent of use of
the United States treaty network by earners of illegal
income, or by persons who have moved money from the United
States for tax evasion purposes. There is, however, evidence
of such use.

Treaty oriented tax evasion includes: (a) recycling
funds earned (legally or illegally) in the U.S. or abroad
back into the United States through a treaty country after
it has first been laundered in a non-treaty tax haven jurisdiction;
(b) fraudulent use by United States persons to remove income
from the United States at reduced rates of tax by masquerading
as foreign taxpayers; and (c) fraudulent use by foreigners
to obtain benefits of treaty rates.

160

1 . Methods of Use

A United States person who has earned illegal income
from, for example, narcotics trafficking, might carry that
income in cash to the Cayman Islands. In the Caymans, the
money would be placed in a trust account with a small private
bank. Those funds could then be used to capitalize an
Antilles bearer share company. The Antilles company could
in turn invest in United States real estate, taking advantage
of the treaty benefits. Because of the exchange of information
provision in the Antilles treaty, it is unlikely that the
money would be carried directly to the Antilles. However,
the Antilles government cannot determine who the true owner
of an Antilles bearer share company is, nor could it determine
the true owner of any other Antilles company if its shares
are held by a nominee located in a second tax haven jurisdiction.

Fraudulent use of treaties by Unite-3 States persons to
remove passive income from the United States could be accomplished
by forming a corporation in a non-treaty country, having
that corporation in turn establish a second corporation in a
treaty country, and then running passive income (such as
royalties) from the United States to the treaty country and
through it to the second country. Under the treaty, the
payment would be taxed at a reduced rate by the United
States. Because the second company may be in a haven or a
commercial secrecy jurisdiction, the true owners remain
anonymous .

This latter case has allegedly arisen under the Antilles
treaty. Under that treaty, an Antilles corporation owned by
a Dutch corporation is entitled to receive royalties free of
United States tax. The United States payee can pay the
royalties, without withholding, jjf certification of Dutch
ownership by the Antilles government is provided by the
Antilles company. (Certification is indicated on a "VS-4"
certificate.) The Antilles government does little checking
to see who owns the Netherlands company. They also do not
check, in all cases, to see whether the Antilles company is
filing a tax return. Because the VS-4 is good for three
years, three years can go by before anybody realizes that
the Antilles company is not paying tax. By that time„
whatever fraud was planned may have been completed. — '

16 / Where the Antilles entity is not owned by a Dutch

resident, certification of entitlement to treaty bene-
fits is given by a VS-3 which is good for only one year.
Similar problems have apparently arisen for payments
covered by a VS-3.

161

Another fraudulent use of treaties by foreigners has
allegedly arisen under the Antilles treaty. That treaty
provides for a zero rate of tax on interest payments from
the United States to an Antilles resident who does not take
advantage of the special low rate of tax accorded Antilles
investment companies. A third country resident wishing to
lend funds into the United States can establish an Antilles
company, capitalize it, and have the company lend the money
into the United States. The interest payments from the United
States to the Antilles company are free of United States tax.
If, however, the interest is paid to the controlling shareholders
of the Antilles company, the Antilles company may not be
permitted to deduct that interest. Accordingly, the regular
corporate rate (30 percent) will be applied to the interest
received .

To avoid this tax, and the necessity of establishing an
Antilles company, a foreigner can deposit, in an Antilles
bank, an amount equal to the amount of the loan he wishes to
make. The Antilles bank then lends the proceeds to the United
States person. The Antilles bank will receive interest from
the United States person, subject to the zero rate of tax
under the treaty. The interest, and eventually the principal,
are then remitted to the nonresident, with the bank retaining
a small fee.

Under this scheme, the bank would insist upon security
for the loan, which would be documents signed by the foreign
person. This scheme is fraudulent because, if the IRS agent
knew all of the facts (the existence of some kind of security
agreement between the nonresident and the bank), the loan
would clearly be considered a direct loan by the foreign
person to the United States person, which does not qualify
under the treaty because the foreign person is not a resident
of the Antilles.

At times, back-to-back arrangements might also be
considered fraudulent. For example, the use of a Dutch
holding company to sublicense patents into the United States
would be tax fraud if the recipient of royalties paid by the
Dutch company did not pay the United States tax on those
royalties known to be subject to United States tax.

2. Analysis of Illegal Use

As in any other case of tax fraud, the problems in
dealing with fraudulent use of treaties are of detection,
investigative techniques, and the ability to gather evidence
which can be used in a criminal prosecution. The schemes
described above depend, to a large extent, on the anonymity

162

afforded by a tax haven country. For example, the use of an
Antilles bearer share company makes it difficult to identify
the true owners of the company. Likewise, bank secrecy
policies make it difficult to identify the relationship of a
bank depositor and a bank loan. Layering of entities in
treaty and non-treaty countries makes detection even more
difficult. As in many other areas, complexity plus information
gathering difficulties makes it hard to identify the improper
or fraudulent transactions.

E. Administration of Tax Treaty Network

Treaty issues involving foreign investment in the United
States and treaty issues involving foreign persons doing
business in the United States are generally under the jurisdiction
of the IRS Office of International Operations (010). Treaty
issues involving United States investment overseas are under
the jurisdiction of the Examination Division, and are most
often addressed by agents in its International Examination
Program.

Procedural treaty matters such as exchanges of information
and competent authority cases are generally handled by 010.
Certain exchanges of information pursuant to the simultaneous
examination program, and spontaneous exchanges of information,
are handled by the Examination Division. Tax treaties are
negotiated by the Office of the Assistant Secretary of the
Treasury for Tax Policy, specifically the Office of International
Tax Affairs. That Office also gives policy guidance in the
interpretation of the treaties.

Tax haven treaty issues most often involve the question
of whether a payment of passive income to a tax haven qualifies
for an exemption or reduced rate of tax under a treaty. One
of the most important administrative tools available to the
IRS is the withholding of tax on payments to foreigners. — '
Present regulations require withholding of the statutory 30
percent tax on United States source, gcoss income when the
income is paid to a foreign person. — ^ An "address" system
is used for dividend income under which withholding is
at the reduced treaty rate, if the address of the dividend
recipient is in a treaty country. With respect to other
income, a self-certification system is in effect under which

\1_/ §§1441 and 1442.

18/ Treas. Reg. §1.1441-1.

163

the recipient of the income can claim a treaty reduction or
exemption by filing a Form 1001 with the withholding agent.
Once claimed, an exemption is valid for three years. Under
this system, a foreign trustee or an officer of a corporation
resident in a treaty country can file the Form 1001 and
achieve the treaty reduction. The withholding agent is
under no obligation to look behind the claim and the IRS is
not notified of the claim before payments are made. Accordingly,
there is no practical opportunity for the IRS to determine
qualification for exemption before a payment is made.

For example, a Dutch company licenses a patent to a
United States manufacturer. The Dutch company supplies the
manufacturer with a Form 1001 claiming the benefits of the
United States-Netherlands income tax convention, which
provides that industrial royalties paid to a Dutch resident
are exempt from the 30 percent Uhited States tax. The IRS
may, however, wish to independently determine whether the
Dutch company is entitled to the exemption. For example,
the IRS may wish to determine whether the Dutch company is,
in reality, an agent of a resident of a third country, or if
the Dutch company itself is paying out the royalties to a
resident of a non-treaty country, in which case the royalties
are United States source income and subject to tax by the
United States. To make these determinations, the IRS would
want the records of the Dutch company to determine whether
it is the effective owner of the patent. IRS may wish to
know the owners of the company, and it may wish to know
whether the Dutch company is making payments (such as interest)
in lieu of royalty payments. Much of this information could
be obtained under the exchange of information provision of
the treaty, but this takes time. In addition, the information
sought might be protected by the secrecy laws of the treaty
partners. If some of the information is not available, then
it may be necessary to audit the books of the company or
talk to its personnel. All of this is time consuming, and
some tax havens might not permit it. Furthermore, by the
time the IRS can gather the necessary facts, all of the
income may have been paid out; the tax may have become un-
collectable.

Effective administration of tax treaties and the anti-
abuse provisions contained in them are limited for at least
three reasons. First, because effective administration
depends upon the full and willing cooperation of the treaty
partner's tax administration. This involves a commitment of
their resources and the availability of the necessary
expertise.

164

The anti-abuse provisions of the treaty operate when a
nonresident of a treaty country seeks to take improper
advantage of the treaty, usually through a holding company
or a trust or nominee account in the treaty country. Information
as to ownership of an entity and the residence of the owner
is in the hands of persons within the jurisdiction of the
treaty partner. Therefore, any application of the anti-
abuse rules requires an inquiry by the tax administrators
of the treaty partner into the residence of the owners of
the entity. The IRS can do very little to adequately administer
these provisions without the full cooperation of the treaty
partner.

For example, the holding company anti-abuse rules in
the proposed Cyprus treaty apply to deny certain benefits if
a Cyprus company is owned "directly or indirectly" by non-
residents of Cyprus. The only way the IRS can tell whether
a Cyprus company is owned by non-residents is by being able
to look behind any required documentation. If the stock is
owned by a Cypriot individual, the only way to determine if
he is the true owner, rather than a nominee, is to investigate
him, which may involve interviewing him. The IRS does not
have the resources to conduct this kind of examination on a
wide scale, nor can we expect our treaty partners to permit
it.

It is not clear that most of our present or prospective
tax haven treaty partners have the resources or expertise to
make the inquiries on a regular basis. Many promote themselves
as tax havens, and it may not be in the best interest of the
tax haven to vigorously administer the anti-abuse provisions.

Second, proper administration of the treaties depends,
to a great extent, on a meaningful exchange of information,
which in turn depends upon the scope of the information
which can be provided under the exchange of information
article. The articles in the existing tax haven treaties do
not override local commercial secrecy laws or customs. They
also do not obligate our tax haven treaty partner to obtain
any more for the United States then they obtain for themselves.
Accordingly, the IRS cannot always expect to get the information
needed to determine whether third country residents are
improperly using the treaties. In the existing Model treaty,
the exchange of information article does follow the OECD
article, and we can anticipate negotiation problems if we
deviate from it. Nevertheless, the article does contain
gaps when dealing with a jurisdiction which has commercial
secrecy.

165

Third, administration at a level which can prevent
abuse of the treaty would require a much greater committment
of resources than are presently available. The IRS has
limited resources which it can devote to administering tax
treaties. In 1979 only about 75 Form 1042's (the form which
must be filed by a United States person making a payment to
a foreign person) were audited. Despite a growing treaty
network, the Congress has not made available additional
resources necessary to administer the treaties. The IRS
simply is not in a position to audit tax haven holding or
insurance companies claiming treaty benefits to determine if
they are eligible for those benefits.

Furthermore, there are practical limitations. Effective
administration of anti-abuse provisions most likely involves
auditing tax haven entitites. This infringes on the sovereignty
of the tax haven. It is unlikely that a tax haven would
permit any large scale activity of this kind.

IRS rulings policy has not always kept up with developments
in the use of tax haven treaties. IRS rulings show an
inconsistent policy toward treaty shopping, which reflects
equally inconsistent Treasury and Congressional policies.

The IRS has attempted to deal with some of the most
obvious abuse cases while at the same time permit ing_some
treaty shopping. For example. Revenue Ruling 79-65 — held
that dividends paid by a United States subsidiary to its
Netherlands Antilles parent company were not eligible for
the five percent withholding rate provided by the United States-
Antilles treaty, because the United States subsidiary had
not provided the information, when requested by the IRS, to
establish that the relationship between it and its Antilles
parent was not "arranged or maintained" primarily to secure
the five percent rate. The sole shareholder of the Antilles
company was an individual who was not a United States person,
or a citizen or resident of the Netherlands, the Antilles,
or any other country having a treaty with the United States.

While the ruling denies the five percent rate, it does
so under the "arranged or maintained" language in the treaty
(which is not in the United States Model and is found only
in a few of our older treaties), and indicates that the dividend
may qualify for the 15 percent rate allowed under the treaty
if the recipient is a resident of or a corporation of the
Antilles. Even the 15 percent rate places a pr^gium on
treaty shopping. See also Revenue Ruling 75-23 — ''^ and

19/ 1979-1 C.B. 458.
20/ 1975-1 C.B. 290.

166

21/
Revenue Ruling 75-118 — ' which indicate approval of the use

of the Antilles and the Netherlands, respectively, by persons

who are not resident in either country.

The United Kingdom treaty extensions (the BVI , etc.)
provide for a 15 percent rate of United States tax on dividends
derived from a United States corporation by a resident of a
former United Kingdom territory who is subject to tax by
that former territory on the dividend. The rate is five percent
if the corporate parent controls 95 percent of the voting
power of the payor, and if the passive income limitation is
met. The reduction to five percent does not apply "if the
relationship of the two corporations has been arranged or is
maintained primarily with the intention of securing such a
reduced rate." — ^ The dividend article contains a provision
permitting either party to terminate the article under
notice to the other party.

The "arranged or maintained" language in the context of
the United Kingdom extensions has not been interpreted.
There are no published IRS positions, and the issues do not
seem to have been raised on audit.

Another problem in tax treaty administration is the
lack of adequate coordination between Treasury's Office of
International Tax Counsel (ITC) and IRS, and lack of coor-
dination with the Tax Division of the Department of Justice
(Tax Division) on exchange of information problems. Today,
coordination appears to be on an ad hoc basis. Only if ITC
has a problem, do they coordinate. As a result, it is
possible that inadequate attention is given to tax administration
concerns in formulating treaty policy.

F. Options for Tax Haven Treaties

Tax haven treaties present special problems because the
combination of low rates of tax imposed by the other country
and the reduction in United States tax rates by reason of
the treaty attracts third country residents to use the
treaty to invest in the United States. Accordingly, when
attempting to deal with tax haven treaty problems, we are
attempting to limit treaty shopping. This could be done by
administrative, legislative, or treaty policy changes. The
best approach, of course, is not to have treaties with tax
havens. Other factors, however, often make that goal unattainable,

21/ 1975-1 C.B. 390.

2 2 / Article VI United States-United Kingdom Income Tax

Convention of July 25, 1946, as extended to the United
Kingdom territories.

167

1. Administrative Options

Many of the investment patterns described above are
permitted by the literal language of the treaties. There
are, however, some which are not, and administrative actions
might be taken which might help in dealing with some of the
problems.

Consideration should be given to the following options
for curtailing tax haven treaty abuse.

a. Refund system of withholding . The present system
of withholding could be changed to a refund system. Many of
the schemes involve the use of a treaty to obtain a reduced
rate of tax at source. In order to qualify, all that the
foreign taxpayer need do is submit a form or letter to the
withholding agent once every three years.

Under a full refund system, withholding would be at
the statutory rate, and the reduced rates accorded by the
treaties would be available only upon application for a
refund by the affected foreign investor. The application
would include a certification from the treaty partner that
the investor is entitled to the benefits of the treaty. The
United States certifies for Belgium, France, Luxembourg, and
the United Kingdom. A refund system would at least force
the foreign investor to submit a claim with the government,
which could in itself curtail some of the more abusive use.
It would also give the IRS a better opportunity to identify
cases for audit.

A refund system, however, can be expensive to administer.
Moreover, those who can afford competent tax advice can
often get around it. It can be argued that what is created
is really just a loan to the united States Government without
any meaningful reduction in abuse.

As an alternative, a "certification system" could be
adopted under which withholding would be at the statutory
rate, unless the investor submitted a certification from the
treaty partner that he was entitled to the reduced treaty
rate. A combination of the two is also possible. Under
this system, withholding would be at the statutory rate for
the first year in which a payment is made. The investor
would then file for a refund and include a certification of
eligibility from the treaty partner. Thereafter (or for a
fixed period of years), withholding would be at the reduced
treaty rate.

168

b. Increase audit coverage of treaty issues . Consideration
should be given to expanding the audit coverage of foreign
investors claiming treaty benefits. One possibility is to

use the tables which list the tax haven payees who receive
income (the 1042 tables) in an attempt to identify quality
cases .

Clearer directions could be given to examining agents
in the finance company area, and better training in the
treaty area could be provided. There is an ambivalence in
the law and in IRS rulings policy which in the past has
been reflected in agents generally not auditing many finance
company cases. Some agents appear to avoid finance
subsidiary issues on the theory that they had subpart F
income in any event. This analysis shows a need for better
understanding of the treaty issues involved. The IRS
should develop a clear policy toward finance subsidiaries,
and make that policy known to the examining agents.

c. Periodic review of treaties . Treasury should
consider subjecting treaties to a regular periodic review.
Jurisdictions that have treaties in effect that are abused,
or are not in the best interest of the United States, would
be notified of termination. Priority renegotiation would
then be instituted. In this way, the pressure to renegotiate
would be placed on the treaty partner. Congress might pass
legislation requiring that results of this review be made
available to the public and subject to Congressional scrutiny.

In order to facilitate this option, a change could be
made in the termination clauses of the treaties. Under most
of the existing treaties, notice of termination must be
given at least 6 months before the termination date. The
treaty then terminates as of the first day of January next
following the expiration of the 6 month period. Accordingly,
the Treasury would have at most one year to negotiate a
treaty and have it approved by the Senate. This is not
enough time. This problem could be solved by making it
clear that the notice of termination can be effective the
first of a designated January which is at least 6 months in
the future. Thus, more than one year could be allowed for
renegotiation, but with a fixed termination date.

Adoption of this option would require that additional
resources be made available to the Treasury.

d. Exchange of information article overriding bank
secrecy . The exchange of information article in U.S. tax
treaties with tax havens could be strengthened to override
local bank and commercial secrecy. This issue and a possible
approach is discussed in Chapter IX.

169

e . Improve the quality of routine information received .
Attempts should be made to improve the quality of the
information which we get from our tax haven treaty partners.
In many cases, the information which we receive from our
treaty partners is not in usable form. Often, details
necessary to identify a United States taxpayer receiving
income are not available. This makes it difficult to identify
United States persons who may be receiving income from a tax
haven and not reporting it. Furthermore, the IRS does not
get information which is useful in dealing with treaty
shopping. Moreover, the exchange of information articles in
the treaties do not override bank secrecy, which means that
important information is often not available.

f. Rulings . IRS rulings policy has at times appeared
ambivalent with respect to the use of tax haven treaties by
treaty shoppers. At times taxpayers get the impression that
the IRS condones such use. To dispel this impression, the
IRS could attempt to challenge the back-to-back royalty
situation, by taking the position that amounts paid by a
corporation in a treaty country are United States source
income and are not exempted by the language of the treaty.
For example, as described above, patents may be licenses
into the United States through a company established in the
Netherlands. The United States-Netherlands treaty provides
that royalties paid to a corporation of one of the contracting
countries are exempt from tax by the other contracting

country. Accordingly, royalties paid by the United States licensee
to the Netherlands company are exempt. The IRS could argue,
however, that royalties paid by the Netherlands company to a
third country national are royalties for the use of a patent
in the-United States and accordingly are United States source
income—''^, and that the Netherlands company is a withholding
agent required to withhold the United States tax of 30
percent of the gross amount paid. While it would be difficult
for the IRS to enforce the withholding obligation of the
Dutch company, the payments to the Dutch company could be
attached .

The IRS could also publish a ruling stating that any
United States investment through a former United Kingdom territory
will be closely scrutinized, with a view toward determining
whether the "arranged or maintained" language is applicable
to deny the five percent rate. A procedure could be adopted
under which the reduced rate will not be granted, unless a
prior ruling is obtained that the arrangement between a United
States corporation and a corporation resident in the treaty
partner has not been and will not be aranged primarily with
the intention of securing the reduced rate.

23/ See §861(a) (4) .

170

g. Coordination with ITC . ITC should consider coord-
inating with IRS and the Tax Division on a more regular
basis when formulating treaty policy. This would enable ITC
to be better aware of the administrative and law enforcement
problems faced by the administrators who will have to deal
with the treaties. It might also give tax administration
considerations more weight in formulating treaty policy.
Efforts to improve coordination -within the IRS would make
coordination with ITC easier. — ^

2. Changes in Treaty Policy

The options set forth below are intended to apply to
treaties with tax havens, and are intended to help limit the
use of tax haven treaties by third country residents. It is
this use of treaties by third country residents which creates
whatever problems are caused by treaties.

a. Treaty network . The most direct attack on tax
haven treaty problems would be not to have treaties with tax
havens. Solely from a tax administration perspective, the
United States should not have standard treaties with tax
havens.

The United States should consider terminating its
existing tax haven treaties, particularly those with the
Netherlands Antilles and the former United Kingdom territories.
The United Kingdom extensions are an affront to sound tax
administration, existing only to be abused. The Antilles
treaty has also been regularly abused. The IRS has not had
much success in enforcing the anti-abuse rules.

It is recognized that for non-tax considerations, it may
be necessary to enter into tax treaties with tax havens.
Such treaties should be as limited as possible, and should
focus on the specific policy objectives for negotiating the
treaty. They should contain a strong exchange of infor- „j. ,
mation provision which overrides secrecy laws and practices. — '

In order to prevent some of the smaller Western Hemis-
phere jurisdictions (and perhaps jurisdictions in other
areas) from becoming aggressive tax havens, we might con-
sider entering into limited income tax treaties with them.
These treaties could provide for competent autority procedures
to deal with transfer pricing and allocation problems. They

24 / See discussion in Chapter X, supra.

2 5 / See Chapter IX for suggested model exchange of information
article.

171

could contain a non-discrimination provision. They should
also contain a strong exchange of information provision,
similar to that discussed in Chapter IX. They might also
obligate the LMited States to provide technical assistance
for tax administration. Further, the termination Article should
contain a provision providing that either party can terminate
the treaty, if either determines that the other party is not
able to administer the anti-abuse provisions of the treaty
or is not meeting its obligations under the treaty.

b. Source country taxation . Present treaty policy,
which is consistent with the OECD approach, is to give
primacy to tax to the country of residence of the earner of
income, except in the case of business income and income
from real property. Even in the case of business income,

the treaty approach is more restrictive of the source country's
jurisdiction than is the Internal Revenue Code. This policy
should be reconsidered with respect to tax havens or juris-
dictions which have the potential to become tax havens.

One solution to the tax haven treaty shopping problem,
which is reflected generally in the approach of the developing
countries — ' , would be to adopt a policy of giving the
source country the primary right to tax income. The reductions
in tax on the gross amount of passive income (dividends,
interest and royalties) would be limited, some significant
United States tax on the investments would be preserved, and
the incentive to shop for the best possible return would be
limited. Further, the categories of income considered to be
business profits could be restricted, and more categories
could be subjected to gross tax.

c. Anti-holding company or anti-conduit approaches.
Article 16 of the united States Model and similar provisions
in a number of existing treaties attempt to limit the use

of the treaties by third country residents through an investment
or holding company. There are also other anti-abuse provisions
contained in the treaties. These provisions do not appear
to be effective in preventing treaty abuse.

One or more of the following approaches could be adopted
to deal with tax haven treaty shopping, the goal being to
eliminate third country use of these treaties. In general,
treaties with countries that are or that have particular
potential to become tax havens should contain as many useful
anti-avoidance provisions as possible.

26 / Manual for the Negotiation of Bilateral Tax Treaties
Between Developed and Developing Countries , United
Nations Publication ST/ESA/94 (1979), discussion of
interest guidelines at 66-73.

172

(i) Article 16 of the Model could be expanded to con-
form to the proposed Cyprus treaty — ' , to deny reduced rates
of tax in the case of payments to a company (1) that is
owned 25 percent or more by non-residents of the treaty
partner, or (2) whose income is subject to tax in the other
state at a rate substantially less than the normally applicable
corporate rate. In dealing with potential tax havens, this
approach would be an improvement over the existing provision.
It does, however, contain the same administrative difficulties.

(ii) Article 16 could be expanded to deny treaty benefits
to a company if more than a stated percentage of its gross
income is passive income. A payment to a holding company
would not be eligible for reduced withholding taxes, regard-
less of the ownership or tax burden borne by that company in
the home country. In the alternative, the passive income
test could be combined with the ownership test in (i) above,
or with the ownership and reduced rates of tax test. The
reduced rates of tax would be denied to a company which
receives a substantial amount of passive income, and which
is subject to a reduced rate of tax in the home country,
even though it is owned exclusively by residents of the
treaty country.

(iii) The holding company test could be abandoned in
favor of a more direct approach. For example, the reduced
rate of tax on interest could be denied with respect to a
debt obligation that is created or assigned mainly for the
purpose of taking advantage of the reduced rate of tax, and
not for bona fide commercial reasons. A similar provision
for royalties could be included, under which the reduced
rate of tax would not be available if the right or property
giving rise to the royalty was created or assigned mainly
for the purpose of taking advantage of the reduced rate of
tax, and not for bona fide commercial reasons. — '

d . Expansion of anti-abuse provisions to active business .
The Article 16 approach could be expanded to cover all
treaty rules. Article 16, and most anti-treaty shopping
provisions, apply to dividends, interest and royalties.
They do not apply to a corporation established by a third

27/ Article 26.

28 / See Articles 12 and 13 of the Netherlands-United Kingdom
Income Tax Treaty, as amended by protocol entering
into force on October 19, 1977.

173

country resident to conduct an active business in the United
States. Accordingly, a third country resident wishing to
conduct an active business in the United States can form a
resident corporation in a treaty country, and take advantage
of the benefits accorded by the permanent establishment
rules and any other benefits given by the convention. This
use of treaties could be curtailed by extending the anti-
holding company rules to all activity carried on by a corporation
owned by third-country residents.

e. Second withholding tax . The second withholding tax
should not be waived when the treaty partner does not impose
a tax on payments out. The waiver of the United States tax
imposed upon payment of dividends and interest by a foreign
corporation is an important element in successful treaty
shopping. This waiver permits the income to be paid from
the treaty country to the owner of the income free of tax.
By insisting on retaining the second withholding tax, this
element is removed. See 3.c. below for a legislative suggestion
dealing with replacing the second withholding tax with a
branch profits tax.

f. The insurance premium exemption . The United States
imposes an excise tax on insurance or reinsurance premiums
paid to foreign insurers. — ' The rate is four percent of
the premium, or one percent in the case of reinsurance. The
United States-United Kingdom treaty gives up the tax on
payments of -.insurance or reinsurance premiums to a United Kingdom
enterprise . —

The exemption has allegedly been abused, and some of
the premiums may be flowing through insurance companies
resident in a treaty partner (particularly in the United Kingdom)
to insurance companies or reinsurers located in tax havens
such as Bermuda. In some cases, the tax haven company may
be owned by the United States company, but this relationship
is hidden. Further, if the foreign company is not paying a
significant rate of tax in its real country of residence, it
has a competitive advantage over United States insurers.
While, in theory, a tax is due when the treaty country
insurer lays off the risk to a foreign company, in fact, any
procedures to collect such a tax would be unenforceable.

29/ §4371.

30/ Article 7 (6A) .

174

(i) The broad exemption from the excise tax imposed on
insurance or reinsurance premiums paid to foreign insurance
companies could be eliminated.

(ii) The IRS could adopt, generally, the position taken
in the French protocol, under which the exemption is applicable
only "to the extent that the foreign insurer does not reinsure
such risks with a person not entitled to .exemption from such
tax under this or another convention." — ' This approach has
the administrative problems of any anti-treaty abuse pro-
vision: dependence upon our treaty partner to enforce a
provision it may be unable to enforce or which it may have
no interest in enforcing. An additional administrative
problem is that, generally, pools of risk, not single risks,
are reinsured. This makes any anti-abuse provision difficult
to administer, even with a fully cooperative treaty partner.
The taxpayer could be put to his burden of proof that the
premiums were not passed through, if problems are suspected.

g. Personal service companies — artists and athletes .
The United States Model contains an article which deals with
the so-called lend-a-star problem, by permitting the country
in which services are performed by an artist or an athlete
to tax the income from performance of the services where the
income in respect of the service accrued to another. — ' The
model provision is based on Article 17 of the L&iited Kingdom
treaty.

As explained above, the provision does not deal clearly
with amounts paid for works created by the artist. The real
problem with taxing the income from record sales, for example,
is defining what that income is, i.e., income from the
performance of services or royalties. If the income is
service income then arguably it should be taxed where the .,_ .
services are performed, which is where the record is recorded. — '
If the compensation is royalty income the result may be
different. This conflict could be handled in the treaties
by further defining what the income is and how it will be
taxed. In the alternative, it could be dealt with by amending
the Code to establish clear source rules.

— Art. 1(a) united States-France Income Tax Convention.

32/

— ' United States Model, Art. 17.

33/

=-^' See Ingram v. Bowers , 47 F. 2d 925 (S.D.N.Y. 1931);

aff'd, 57 F. 2d 65 (2d Cir. 1932).

175

An alternative is to treat the compensation from the
use of any copyright of literary or artistic work as business
profits, and attributable to a permanent establishment or
fixed place of business in the country where entertainment
activities are performed, if the royalties are earned
within a fixed period of time after the artist has performed
in the United States. Under this system, the amounts from
the sale of the records would be taxed on a net basis when
paid to the tax haven company. Another alternative is to
clearly define the income as royalties, and not have a zero
rate of tax on royalties, at least in tax haven treaties.

3 . Legislative Approaches

The best approach to dealing with treaty problems is to
handle them through the negotiation process. Some of the
problems can, in part, be dealt with through administrative
changes. There are, however, some legislative options which
should be considered for dealing with tax haven oriented
treaty problems. As with any other treaty legislation
directed at tax havens, a decision would have to be made
whether any legislative approaches would apply generally, or
would apply solely to tax haven transactions.

a. Reduction of the rate of tax on fixed or determinable
income. One possible approach is to reduce the 30 percent
tax which the United States currently imposes on fixed or
determinable income paid to foreigners. Many claim that our
current rates are high. For example, when imposed on interest
paid to a bank, they can exceed the net income of that bank.
Treaties are the mechanism by which we bring our rates down
to a more reasonable level. In lieu of the treaty approach,
we could rationalize our rates of tax legislatively. If the
rates are set at a rate which is higher than current treaty
rates, the legislation could override the treaties, or, in
the alternative, the legislation could provide a maximum
rate with the treaties continuing to take precedence.
Legislation to eliminate the tax on portfolio interest has
been proposed, but to date the Congress has failed to act on
that proposal.

As an anti-haven measure, the present 30 percent
statutory rate could be continued for payments to designated
tax havens, or an even higher rate could be imposed.

176

b. Anti-treaty abuse rule . Another possibility is to
place an anti-treaty abuse provision in the Code. The Code
could be amended to deny treaty benefits to a foreign person
who is not a contemplated beneficiary of treaty benefits, or
if a substantial part of the treaty relief benefits persons
not entitled to the benefits of a convention. This provision
would give the IRS the authority to deny treaty benefits in
abusive cases which might come within the literal language

of the treaties, but which were not anticipated by the
treaty negotiators. The provisions could be drafted by
simply referring to a person who is not a contemplated
beneficiary, leaving the IRS with broad authority to develop
guidelines. An objective standard could be included to deny
treaty benefits in the case of payments to a foreign entity
if (1) more than a fixed percentage of income for which the
treaty benefit is claimed is paid to a person not entitled
to the benefits of the treaty, (2) the income is not reported
as taxable income to the treaty partner, or (3) the debt to
equity ratio of the recipient company exceeds a designated
level .

In the alternative, or in addition, an anti-holding
company provision similar to that contained in the United
States Model or the more extensive provision contained in
the proposed Cyprus treaty could be added to the Code. Such
a provision might be applicable only with respect to designated
tax havens.

c. Branch profits tax . The second withholding tax
problem may also be handled through legislation. As dis-
cussed above, some countries, particularly tax havens, do
not impose a tax on payments from their domestic corporations
to non-residents of the tax haven. The United States,
however, imposes a tax on dividends and interest of foreign
corporations which earn a certain percentage of their income
in the United States. Some treaties waive this second
withholding tax, and even when not waived it can be difficult
to collect because the withholding agent is the foreign
corporation. An alternative, used by numerous countries, is
to impose a branch profits tax on the income of a United
States branch of a foreign corporation. Under this approach,
a tax equal to the withholding tax imposed on fixed and
determinable United States source income would be imposed on
the branch when it remits income to its foreign office.

This removes the collection problem and is a somewhat more
rational system. This tax could be waived in appropriate
treaties, but not in treaties with tax havens.

177

Table 1

U.S. Gross Income Pild to Nonresident Aliens

and Foreign Corporations in Tax Havens and Other Jurisdictions

Within and Without the U.S. Treaty Network, by Type of Income, 1978

(In Thousamls of Dollars)

Total

Gross

Income

Dividends

Interest

Other

All countries, total

4,451,059

2,867,596

990,949

592,514

Treaty countries, total

3,947,926

2,595,741

826,882

525,304

Tax haven treaty

countries, total

1,797,378

1,388,314

308,553

100,511

Antigua

2,808

3

2,798

7

Barbados

496

300

121

75

Belize

108

87

1

20

British Virgin I

slands

8,195

5,423

1,716

1,056

Dominica

30

15

*

15

Falkland Islands

122

1

-

121

Grenada

2

1

1

-

Luxembourg

21,066

14,195

5,968

904

Montserrat

4

4

-

1

Netherlands

415,266

331,680

35,499

48,087

Netherlands Antilles

190,759

51,207

127,021

12,531

St. Chrlstopher-

Nevis-Anguilla

396

392

1

4

St. Lucia

7

6

-

•

St. Vincent

1

1

-

*

Seychelles

10

9

1

*

Switzerland

1,158,108

984,991

135,426

37,690

Non-tax haven trea

ty

countries, total

2,150,548

1,207,427

518,329

424,793

Australia-

28,431

6,011

1,265

21,155

Austria

7,358

4,542

1,437

1,380

Belgium

105,421

54,408

37,868

13,146

Burundi

31

2

20

9

Canada

591,695

282,727

187,426

121,542

Denmark

4,678

2,289

308

2,080

Finland ,
France-

949

166

128

654

308,492

213,735

51,520

43,237

Gambia

2

*

-

2

Germany, Federal

Republic of

177,536

124,459

18,882

34,196

Greece

5,337

3,167

714

1,455

Iceland

181

94

*

87

Ireland

5,589

4,093

532

964

Italy

42,982

8,631

11,333

23,017

Jamaica

693

83

5

604

Japan

207,410

63,279

97,216

46,915

Malawi

16

16

*

-^^Includes Norfolk Island and Papua New Guinea.

— Includes French Guiana, Guadeloupe, Martinique and Reunion.

178

U.S. Gross Income Paid fo Nonresident. Aliens
and Foreign Corporations in Tax Haven and Other Jurisdictions
Within and Without the U.S. Treaty Network, by Type of Income, 1978

(In Thousands of Dollars)

3/
New Zealand-
Nigeria
Norway
Pakistan
Poland
Romania
Rwanda

Sierra Leone
South Africa
Sweden

Trinidad and Tobago
U.S.S.R.
United Kingdom
Zaire
Zambia

Non-treaty countries, total

Tax haven countries
Non-tax haven countries

Total

Gross

Income

Dividends

Interest

Other

3,563

1,811

640

1,112

253

80

*

173

5,398

3,816

480

1,102

673

47

12

614

883

206

88

589

130

26

29

75

2

2

*

-

20

5

2

13

2,627

1,314

392

921

28,568

18,696

5,309

4,563

209

81

13

115

510

A3

63

404

620,822

413,527

102,643

104,653

32

20

*

12

57

53

3

2

503,133

271,855

164,067

67,211

97,475

67,536

15,061

14,879

405,658

204,319

149,006

52,332

3/

— Includes Cook Islands and Nlue.

*Le8S than $500.

Note: Detail may not add to totals due to rounding.

Source: Statistics Division, Internal Revenue Service, unpublished tabulations on
"Nonresident Alien Income and Tax Withheld as Reported on Forms 1042s" for
Calendar Year 1978.

179

Table 2

U.S. Gross Income Paid to Nonresident Aliens
and Foreign Corporations in Tax Haven Countries
Within and Without the U.S. Treaty Network, 1978

(Amounts in Million Dollars)

Amount

Percent of
all countries

Treaty countries, total

3,947.9

88.7

Tax havens
Other

1,797.4
2,150.5

40.4
48.3

Nontreaty countries, total

503.1

11.3

Tax havens
Other

97.5
405.7

2.2
9.1

All countries, total

4,451.1

100.0

Sura of components may not add to totals due to rounding.

Source: Statistics Division, Internal Revenue Service, unpublished tab-
ulations on "Nonresident Alien Income and Tax Withheld as Re-
ported on Forms 1042s" for Calendar Year 1978.

180
IX. Information Gathering

The Secretary of the Treasury has broad authority to
require taxpayers to file tax returns, and to keep records
necessary to determine tax liability.— The Secretary is
empowered to examine any books, papers, records, or other
data that may be relevant, or material to verify the correctness
of any return or to compute any tax liability.— The Secretary's
powers, which are delegated to the IRS, and the IRS' ability
to enforce them are essential to effective administration of
the Internal Revenue Code. In the international sector,
these powers frequently are insufficient for the task.

International transactions in general, and tax haven-
related transactions in particular, present special problems
to the tax administrator. To begin with, U.S. tax laws
governing international transactions are among the most
complex in the Internal Revenue Code. In addition, the
acquisition of information necessary to verify a return or
establish tax liability where such transactions are involved
is always difficult, often impossible. Investigative efforts
are logistically complicated by distance or language differences.
Such efforts are procedurally complicated by internal laws
and practices of other sovereigns. The ultimate stumbling
block is political--the U.S. investigative need often clashes
with a foreign interest. When a tax haven is involved,
conflicts with foreign laws and practices result in more
than merely complex and time-consuming procedures.

A, Reporting

The foundation of the U.S. self-assessment system is
the reporting of income and income-producing transactions by
taxpayers. Reliance on taxpayer-supplied information applies
to international as well as domestic transactions. In both
areas, that reliance gives rise to the following questions:
(1) What information should be reported? (2) Is IRS asking
for it? (3) Is IRS asking for it in a manner that does not
place an undue burden on the taxpayer? (4) Is IRS obtaining
what it is asking for? (5) Is IRS using the information it
gathers?

1/ §6001.
2/ §7602(1).

181

1. IRS Forms

The primary source of taxpayer -suppl led information is
the IRS forms filed by taxpayers. Some forms are used to
compute tax liability. Others report data or the occurence
of certain transactions which do not necessarily reflect the
reporter's tax liability. The IRS forms required of a U.S.
taxpayer to report international transactions are as follows:

Form 959 (acquisition or disposition of an interest
in a foreign corporation);

Forms 926 and 3520 (transfer of property to a
foreign entity) ;

Forms 958 and 2952 (transactions of a controlled
foreign corporation);

Form 3520-A (income of a foreign trust in which
the taxpayer has an interest) ;

Forms 957, 958, and 3646 (receipt of income from a
foreign corporation);

Forms 1042 and 1042S (payment of certain fixed or
determinable income to a foreign person);

Forms 1120NR (corporation) and 1040NR (individual)
(receipt of U.S. income or foreign effectively connected
income by a resident or non-resident foreign corporation,
and a nonresident alien individual, respectively).

The time and place for filing these forms vary. The
time is often controlled by the event to be reported (e.g..
Form 959). Some are filed with the taxpayer's return (e.g..
Form 2952), others are filed separately but at the same
service center where the taxpayer files his return (e.g..
Form 926), while still others are filed at the Philadelphia
Service Center (e.g.. Form 957).

a. Analysis

Problems associated with reporting include: (1) inadequacy
of the information requested from taxpayers, (2) poor quality
of information supplied by taxpayers, (3) overlap among
forms requesting information, (4) ambiguity in filing require-
ments for these forms, and (5) IRS processing difficulties.

With respect to the first problem, there are several
significant reporting gaps.

182

A U.S. person doing business overseas is not required
to report the nature of his transactions. Thus, loans from
foreign entities, a primary method of repatriating funds
laundered through tax havens, need not be reported. As a
result, the IRS is unable to identify returns where audit
would be appropriate.

In addition, there is a gap in the Form 959 filing
requirements. Today, a Form 959 must be filed by certain
U.S. persons with respect to an acquisition of stock in a
foreign corporation if the acquisition results in a U.S.
person owning five percent , or more of the value of the
stock of the corporation.— Stock owned .directly or indirectly
by a person will be taken into account.— The regulations
provide for attribution of stock owned by a foreign corporation
or a foreign partnership to its shareholders or partners.—^
They do not provide for attribution from a foreign trust.

Accordingly, under the regulations, if a foreign trust
for the benefit of a U.S. person acquires stock in a foreign
corporation, the fact of that acquisition does not have to
be reported. If the foreign trust which acquires the stock
is a grantor trust with a U.S. grantor or is a §679 trust,
then the grantor or U.S. person taxable under §679 as the
owner of the property would have to file, because that
person is considered to be the owner of the stock. This
rule is not explicitly set forth in the regulations.

A fiduciary of a foreign trust that has U.S. source
income or that is engaged in a trade or business in the U.S.
must file a Form 1040NR. However, the form does not require
that the fiduciary identify the principal of the trust,
specify whether the trust entity has a U.S. business, or
clarify his relationship to the entity (i.e., trustee,
nominee). As a result, information which the IRS might use
to classify a return is not readily available.

A U.S. beneficiary of a foreign trust which was established
by a foreign person does not have to report his interest in
the trust. As a result, it can be difficult for the IRS to
identify income paid to such a person from the trust.

3/ §6046.

V §6046(c).

5/ Treas. Reg. §1. 6046-1 ( i ) (1 ) .

183

A U.S. partnership is required to report its income and
deduction items on Form 1065, as well as each partner's
distributive share of the partnership income and expenses on
Schedule K of the form. The partnership advises each partner
of his distributive share on Schedule K-1, which the partner
then reports on his return. A foreign partnership has a
duty to file Form 1065 only if it is engaged in a trade or
business in the U.S. A U.S. partner in a foreign partnership
not so engaged in business in the U.S. is required to report
his distributive share of the income and deductible items of
that partnership. However, because the partnership does not
file a Form 1065, the IRS is without details regarding the
nature of partnership income and deductions. As a result,
it is difficult to identify partners of foreign partnerships
for audit.

A U.S. subsidiary of a foreign parent is required, as a
U.S. corporation, to file a Form il20. It need not submit
information concerning its foreign affiliates. Thus the
U.S. subsidiary may engage in transactions with foreign
affiliates v/ithout the IRS being aware of the relationship.
As a result, the IRS may not scrutinize the arms-length
nature of such transactions.

With respect to the second problem, any number of
factors (e.g., placement of questions on forms, clarity of
questions, lack of follow-up by the IRS where responses are
inadequate) come into play, all of which are correctible.

With respect to the third problem, overlap among the
forms certainly exists. Although Form 3646 is used to
compute tax liability (income attributable to certain U.S.
shareholders), and Form 2952 is an information return, both
require much the same information. Lilcewise, Form 957 and
958 often overlap and may overlap with Forms 2952 and 3646
if the foreign corporation is both a foreign personal holding
company and a controlled foreign corporation. Form 959 may
also require information similar to that required on these
other forms. To the extent that overlaping does not serve a
useful tax administration purpose, it places an unnecessary
burden on taxpayers.

With respect to the fourth problem, the multiplicity of
forms, and ambiguity in designating "who should file what",
creates confusion. Not only is it difficult for individuals
to know precisely what form they are supposed to be filing,
it also appears that the IRS also has difficulty in determining
the manner in which to deal with these forms, as discussed
below.

184

With respect to the fifth problem, some required IRS
forms that are filed never get into the regular audit stream
and, consequently, are rarely audited. Until recently, some
required information returns (e.g., foreign trust forms) were
neither associated with relevant individual or corporate
income tax returns nor otherwise used.— '^ For example, Forms

957 (United States Information Return by an Officer, Director,
or U.S. Shareholder of a Foreign Personal Holding Company)
and 958 (U.S. Annual Information Return by an Officer or
Director of a Foreign Personal Holding Company) are filed
with the Philadelphia Service Center, but not forwarded to
the district offices. Thus they are rarely audited or
associated with the U.S. taxpayer's return. In fact, during
extensive field visits with international examiners, only

one examiner was found who had audited a foreign personal
holding company return.

The IRS has taken steps to associate Forms 3520 and
3520-A with the relevant income tax returns. The Philadelphia
Service Center now posts the fact that a related 3520 or
3520-A has been filed in the taxpayer's computerized tax
file (module) in Martinsburg, West Virginia. The existence
of a related 3520 or 3520-A will be noted on the return.
Whether this will prove to be of value has yet to be deter-
mined, since very few Forms 3520 and 3520-A are filed.

b. Options

For taxpayer-supplied information to remain a solid
foundation of the U.S. self-assessment system where inter-
national transactions are involved, change is required.
The above analysis suggests a number of possibilities, both
legislative and administrative.

(i) One possibility is to streamline and improve
existing forms by combining them into fewer forms. If no
other action with respect to IRS forms is taken, the IRS
should reevaluate all existing forms for reporting foreign-
related items and, to the extent possible, combine them into
a single clear and concise form. For example. Forms 957 and

958 covering foreign personal holding companies, and Forms 2952
and 3646 covering controlled foreign corporations, can be
combined into a single form. The IRS has already prepared
draft Form 5741 to replace the above-mentioned forms and

%_/ GAO report, "Better Use of Currency and Foreign Accounts
Report by Treasury and IRS Needed for Law Enforcement
Purposes" (April 6, 1979).

185

Form 958 as well. Prior to disseminating the draft form, it
needs to be updated to reflect changes made to subpart F by
the Tax Reduction Act of 1975, the Tax Reform Act of 1976,
and the Revenue Act of 1978. In addition, it might be
expanded to include the information currently combined on
Form 959. At least two legislative changes are necessary.
The filing date for Form 959 must be changed to require
filing within a fixed period of time after the taxable year
in which the reportable event took place, instead of within
90 days after the event. Also, §6035 must be amended so
that returns relating to a foreign personal holding company
can be filed on an annual basis with the return of the U.S.
filer.

(ii) As an alternative to option (i), the IRS could
create a new all-encompassing IRS "international" form.
IRS could devise one form to be filed by any taxpayer engaged
in any international transaction or having any interest in a
foreign account or entity. Taxpayers could be clearly and
directly advised of the obligation to complete this form by
a reference on Form 1040.

(iii) Consideration should be given to imposing
additional reporting requirements, such as, for example,
the following:

(a) Requiring an individual engaged in any international
transaction to submit a balance sheet identifying assets

held overseas. The requirement could be limited to individuals
with total positive income above a certain level.

(b) Requiring an individual engaged in any international
transaction with a foreign entity to report that transaction
(e.g., where a loan is obtained from a foreign entity,
whether or not the taxpayer has an interest in or association
with that entity). An exemption for transactions under a
minimum amount (e.g., $1,000) might be appropriate.

(c) Requiring a U.S. partner in a foreign partnership
to report the income, deductions, and assets of the partner-
ship in a form similar to that used by U.S. shareholders of
a controlled foreign corporation. Where the partnership has
more than one U.S. partner, permit one to report on behalf
of the others, provided that each U.S. partner refers to
ownership of the partnership interest on his individual
return.

(d) Amending Treasury Regulation §1 . 6046-1 ( i )( 1 ) to
provide that for purposes of determining liability for
filing a Form 959 stock owned directly or indirectly by a

186

foreign trust will be considered as being owned proportionately
by its beneficiaries or grantors. It should be made clear
that a grantor or transferor to a foreign trust who is
otherwise considered to be the owner of the stock of the
foreign corporation will continue to have the obligation to
file a Form 959 with respect to the acquisition of stock of
a foreign corporation.

(e) Placing an additional block on Form in40NR to be
checked by a fiduciary of any foreign trust engaged in a
trade or business in the United States. Further, the fiduciary
should be required to clearly state the capacity in which he

is acting as a fiduciary, and to list any U.S. beneficiaries
of the entity.

(f) Deleting the "ordinary course of a trade or busi-
ness" exemption referred to in question 12 of Form 2952
(Information Return with Respect to Controlled Foreign Cor-
porations). This would provide additional information on
transactions between brother-sister corporations when a U.S.
person is the parent of both.

(iv) IRS should encourage better taxpayer information
reporting. The IRS should work with the Tax Executive
Institute, the American Institute of Certified Public Accountants,
and other interested groups to develop methods for improving
the quality of reports now filed.

2. Rank Secrecy Act Forms

In 1970 Congress, recognizing the ". . . serious and
widespread use of foreign financial facilities located in
secrecy jurisdictions for the purpose of violating American
law"— enacted the Bank Secrecy Act of 1970— which authorized
the Secretary of the Treasury to require reporting of (1)
transactions v;ith domestic financial institutions, (2)
transport of currency into and out of the United States, and
(3) relationships with foreign financial institutions.
Congress intended to enable law enforcement agencies to
secure information which might provide leads to earners of
illegal income. In fact, the Act does provide IRS with a
secondary source of taxpayer-supplied information concerning
assets which may or may not have tax consequences.

a. Transactions with financial institutions

A financial institution covered by the Act is required
to report each deposit, withdrawal, exchange of currency,
payment, or any transfer by, through, or to such financial

7/ H. Rep. No. 91-975, 91st Cong., 2d Sess., 1(1970)
8/ Bank Secrecy Act, 31 C.F.R. §103. 22(a) (1970).

187

institution, on Treasury Form 4789 (Currency Transaction
Report, or "CTR" ) , ifgit involves a transaction in currency
of more than $10, 000. -^ Exceptions are provided.—^ Prior
to July, 1980, transfers or transactions with or originated
by financial institutions or foreign banks were not required
to be reported; nor were transfers between banks and certain
established customers maintaining a fixed deposit relationship
with the bank, provided the bank determined that the amounts
involved were commensurate with the customary conduct of the
customer's business.

In July, 1980, Treasury published new regulations — '
which expand the scope of reporting to (1) require the
reporting of large currency transactions by securities
dealers, foreign banks, and miscellaneous financial institutions,
such as dealers in foreign exchange, persons in the business
of transferring funds for others, and money-order issuers;
(2) require more complete identification of a person dealing
in large amounts of currency; and, (3) restrict the ability
of financial institutions to exempt customers from the
reporting requirements.

Transactions with an established customer maintaining a
deposit relationship have always been exempt from the
reporting requirement. The recent amendment limits this
exemption to certain domestic businesses and requires that
the location and nature of the business be identified in a
report of exempt customers which must be furnished to Treasury.
These changes were made necessary when it became clear that
certain banks were abusing the existing exemption rules,
exempting foreign nationals, boat dealers and others whose
only common trait was that they frequently deposited large
amounts of cash.

A CTR must be filed within 15 days of the qualifying
transaction with the Ogden, Utah, Service Center. The
financial institution must retain a copy of the report for
five years. The original is processed in the Ogden Service
Center. Information on the form is entered into the Treasury
Enforcement Communications System (TECS). The fact that a
CTR has been filed is recorded in several IRS taxpayer
files, so that if a return is audited, the auditor can use
TECS to retrieve the CTR information. The existence of a
CTR is also noted in the IRS' "non-filer check."

9/ 31 C.F.R. §103.
10/ Id.

11 / 45 Fed. Reg. 37, 818 (1980) (to be codified in
31 C.F.R. §103) .

b. Transport of carrency

Each person who transports, mails, ships, or causes to
be physically transported, mailed, or shipped, more than
$5,000 in currency or any other bearer instrument into or
out of the United States, must report the transaction on
Treasury Form 4790 (Report of the International Transportation
of Currency or other Monetary Instruments, or "CMIR"). The
form must be filed with the U.S. Customs Service at the time
of entry into or departure, mailing, or shipping from the
Lfriited States. A recipient of currency must file the form
with the Commissioner of Customs within 30 days of receipt.
The information contained on the form is entered into TECS,
and is thereby made available to IRS agents through that system.

Form 4790 is rarely used by the IRS. The identifying
information on the form is generally incomplete, and most
filers appear to be non-resident aliens.

c. Foreign bank account

In accordance with the authority granted by Title II of
the Bank Secrecy Act, the IRS requires a taxpayer who files
Form 1040 to answer the question whether ". . .at any time
during the taxable year, [that person] had an interest in or
signature authority over a bank, securities, or other financial
account in a foreign country." If the answer is "yes" and
the amount involved is over $1,000 at anytime during the
year, the taxpayer is required to report that account by
filing Treasury Form 90-22.1 with the Treasury Department
on or before June 30 of the following year. Form 90-22.1,
formerly IRS Form 4683, was removed from IRS jurisdiction in
October, 1977, to give freer access to the .information
contained on the form to other agencies. — ^

Upon receipt. Treasury enters onto TECS the name,
social security number, and reference to a microfiche where
a copy of the form can be located. An IRS agent then can have
access to the information contained on the form.

d. TECS

The Treasury Department operates a computerized infor-
mation storage and retrieval system which makes information
available to Federal Government personnel in carrying out
law enforcement functions. The system is the Treasury

12/ See §6103.

189

Enforcement Communication System (TECS). TECS is controlled
by Customs, which places the information into the system.
Information from CTRs , CMIRs, and the Foreign Bank Account
reporting forms is entered on TECS. IRS civil and criminal
investigating agents then have access to the information
through TECS.

e. Analysis

In April, 1979, GAO released its study captioned "Better
Use of Currency and Foreign Account Reports by Treasury and
IRS Needed for Law Enforcement Purposes", highlighting areas
in which return information was poorly utilized. Current
processing of CTRs and foreign bank account forms reflects
an attempt to adopt GAO suggestions. Additional processing
changes are planned and will be implemented. For example,
IRS will begin corresponding with reporting financial
institutions when incomplete CTRs are received.

The IRS has become more aggressive in this area. A
recent notice to all agents reminds them that they are
required "to pursue, in all field and office examinations,
the Foreign Accounts and Foreign Trust questions appearing
on tax returns." Examiners have also been directed to
verify whether the taxpayer filed correctly any required
foreign trust, bank account, or currency reports. A forthcoming
Manual Supplement will make it mandatory for the agent to
attempt to determine the correctness of the answer to the
bank account question, and will re-emphasize the directive
to pursue the above mentioned forms.

The GAO study did not analyze the effectiveness of the
various forms; their utility for tax administration purposes
is still uncertain. Form 4789 probably has the greatest
potential, because it is prepared and filed by an impartial
third party (the financial institution). Just how useful
this form can become may depend upon Treasury's success in
securing better quality reporting from financial institutions.
The information received is still of poor quality, and in
many cases the CTRs are incomplete. It has, however, already
proved useful. For example, CID has found cases of CTRs
filed for transactions by persons for whom there is no
record of income tax returns being filed. CTRs have provided
leads for investigations, and have resulted in referrals to
the IRS civil tax auditors for civil investigation. CTR
portraits have lead to the discovery that banks in a particular
state were generally not filing CTRs.

Skepticism exists as to whether Form 4790 can be useful.
The information secured is of poor quality, probably because
it is filled out by the transporter under hurried conditions,
i.e., at the airport. The limited authority of Customs to

190

The usefulness of the foreign bank account question has
yet to be established. There have been few criminal pros-
secutions for failure to answer the question, and civil
penalties are generally not imposed. However, taxpayers
have been prosecuted and, in at least two instances, convicted
for answering the question falsely. In addition, a false
response can be used in the prosecution's case as evidence
of willfulness, even though the taxpayer is not specifically
charged with answering the question falsely.

Most taxpayers do not answer the foreign bank account
question. Placement of the question on the Form 1040 does
appear to affect the response rate. For tax year 1970, when
the question was at the top of page 2 of Form 1040, 66
percent of the returns filed contained no answer. In 1971
and 1972, when the question was on the bottom of page 1 of
Form 1040 just above the signature line, returns containing
no ansv;er were 4 percent and 6 percent respectively. In
1973 and 1974 when the question was moved to the bottom of
page 2 of Form 1040, the "no-response" rose to 62 percent
and 64 percent respectively. Since 1976 when the question
was moved to Schedule B, the "no-response" rate has ranged
from 20 to 33 percent. It should be noted that TCMP data
for 1973 suggest that only 300,000 taxpayers had foreign
bank accounts. Preliminary TCMP data for 1976 suggests that
perhaps 345,000 taxpayers had foreign bank accounts. This
is a relatively small number of accounts when compared to
the Form 1040 filing population of over 52,000,000. However,
there was more than a four-fold increase in the number of
audit adjustments due to transactions involving foreign bank
accounts, from 7,005 adjustments in 1973, to 31,810 in 1976.

It may be that those taxpayers who do not file a Schedule
B, but do have a foreign bank account, also do not file a
Form 90-22.1. Even if Schedule B is filed with "yes" checked
for the foreign bank account question, there is no routine
verification made that the taxpayer filed the Form 90-22.1 with
Treasury (the form is not to be filed with IRS).

191

The reporting requirement is not comprehensive. Reporting
is required only if the taxpayer has a financial interest in
or signature authority over an account in a foreign country.
It does not cover a U.S. account with a foreign nominee
acting for a U.S. person, or control over other foreign
assets. Nor does it cover an account held by a corporation,
trust or partnership unless the individual has more than a
50 percent interest in the entity. This may exclude accounts
owned by a foreign corporation in which a husband and wife
each own 50 percent of the stock.

The IRS seems to have made substantial progress in
utilizing information currently on TECS. It would seem,
however, that TECS could be put to additional uses in tax
administration, and aid in coordinating investigations involving
two or more agencies, as well as in coordinating IRS investi-
gations. Actions along these lines are being taken.

f . Options

The Rank Secrecy Act reports have proved useful at
times. Their utility increases as more experience is gained.
Some options to be considered for further improvement are
presented below.

(i) Recent amendments to the Treasury Regulation
regarding Form 4789 should improve the quality of the infor-
mation provided; the IRS is taking positive steps to improve
processing of that information. More work, however, is re-
quired. With respect to tax haven cases, some attempt to
verify addresses should be undertaken. Other recent recommendations,
such as increased use of CTR printouts with additional
information on those printouts, should be pursued. Furthermore,
additional attempts should be made to obtain the assistance
of the Controller of the Currency in improving reporting.

(ii) More work is required with respect to Form 4790.
To improve the quality of information on that form, legislative
changes may be required. Initially, Congress should amend
the Bank Secrecy Act to make it illegal to attempt to export
or import currency and to give Customs greater authority to
conduct border searches with respect to currency trans-
portation. H.R. 5961, introduced during 1980, contained
amendments which would have accomplished this.

(iii) With respect to the bank account question, the
following suggestions should be considered.

192

(a) Consideration should be given to improving the
existing placement of the question on the income tax return.
It could, for example, either be returned to page one of
Form 1040 or, at a minimum, placed on side A rather than
side B of Schedule A-B.

(b) The information presently requested could be
supplemented by requiring a taxpayer to report beneficial
ownership of assets acquired or managed by a foreign inter-
mediary (e.g., ownership of U.S. assets managed by a foreign
nominee) .

(c) IRS could encourage better taxpayer information
reporting by, for example, sending a follow-up to taxpayers
who fail to respond to the question. This follow-up could
be limited to those who both failed to check either box and
have a total positive income of over a certain amount (e.g.,
$50,000). In addition, tax return preparers' penalties might
be imposed for failing to answer the question on returns they
prepare.

3. Penalties for Failure to File or Adequately Complete
Forms

a. IRS forms

The Internal Revenue Code provides civil penalties for
failure to file or for filing inaccurate income tax forms
and returns. Criminal penalties are provided for willful
failure to file and for tax evasion. Most civil penalties
are not viewed as severe, and we are not certain how aggressively
they are enforced. For example, §6038 of the Code requires
a U.S. person who controls a foreign corporation to file
Form 2952. Section 6038(b) provides that the penalty for
failure to file is reduction of the foreign tax credit.
Despite complaints by IRS agents that taxpayers do not
properly complete the form, this penalty is rarely, if ever,
imposed. In part, this may be because the penalty itself is
mechanically complicated. Or, the IRS may have determined
that this particular penalty is too severe. Some agents
have stated that they hesitate even to recommend imposition
of the penalty, because it makes the taxpayer more antagonistic
and, if imposed, will be abated anyway.

b. Bank secrecy act forms

Willful violations of the Bank Secrecy Act may con-
stitute either a felony or a misdemeanor. Fines of up to
$500,000 and imprisonment for up to five years are provided
in cases of long-term patterns of substantial violation, and

193

violations committeri in furtherance of certain other Federal
crimes. It is also a felony for any person to make a false
or fraudulent statement in any required report. Any currency
or monetary instruments being transported without the required
report having been filed, or as to which the report omits
material facts or contains misstatements, may be seized and
forfeited to the United States. The Act also provides for
assessing a civil penalty, which may range from $1,000 up to
the amount of currency or monetary instruments seized, less
any amount forfeited.

c. Options

Civil penalties are essential to the enforcement of
filing requirements. As a general proposition, such penalties
should be significant in amount so as to be meaningful,
sufficiently easy to impose so as to be readily available,
and flexible in application so as to be useful toward the
goal of securing taxpayer compliance. The IRS might re-
examine existing penalty provisions and procedures related
thereto, with an eye toward the following:

(i) Seeking legislative changes where the penalties
are inadequate. For example, where a taxpayer fails to file
a properly completed Form 2952, reduction of the foreign tax
credit may be an appropriate secondary penalty to be applied
in flagrant cases. Where a taxpayer required to furnish
information under §6039(a) of the Code fails to do so in a
timely and complete manner, §6038(b) could be amended to
provide a minimum mandatory penalty (e.g., $25,000). The
IRS should also have the option to reduce the foreign tax
credit in gross cases.

(ii) Providing clearer direction to the field regarding
the imposition of penalties. Field personnel must be made
aware that voluntary compliance is promoted through the
exercise of good judgment in assessing penalties. A policy
of imposing penalties in all cases of poorly completed IRS
forms serves only to increase tensions with taxpayers and
clog the administrative and judicial systems. On the other
hand, failure to impose the penalty when merited has a
detrimental impact on voluntary compliance.

R. Books and Records — Foreign Transactions — In General

Many of the tax and information returns previously
discussed give IRS the basic information with which to begin
investigations involving international (or domestic) transactions.
Thereafter, a meaningful audit or investigation of a taxpayer's

194

return may require access to books and records of the taxpayer

or third parties, irrespective of whether such books and

records were used in preparation of the return being scrutinized.

1. General Requirements for Maintenance of Adequate Books
and Records

Every person who is liable for any income or excise tax
must keep such records, render such statements, make such
returns, and comply with such rules and .regulations as the
Secretary of the Treasury prescribes. — ' The Secretary has
promulgated regulations which require a taxpayer to maintain
books and records adequate to establish his tax, liability or
other matters required to be shown on a return. — ' These
records must be kept at a convenient location and must be
accessible to IRS employees. — ' Similar recordkeeping
requirements are specifically directed to a U.S. shareholder
of a controlled foreign corporation "as necessary to carry
out the provisions of subparts F and G. " — ' The Secretary,
by regulation, permits such records to be maintained in a
foreign country, but requires, their production within a
reasonable time after demand. — ' The records required to be
produced are, in general, those necessary to verify the
amounts reported under subpart F or G. — '

2. Penalties for Failure to Maintain Adequate Rooks and
Records

The Internal Revenue Code authorizes a civil penalty of
five percent of any underpayment due to nealigence or inten-
tional disregard of rules and regulations. — ' This penalty
can be imposed for failure to maintain books and records
adequate to establish items of income and deduction. — '

\^/ §6001.

14 / Treas. Reg. §6001-l(a).

15^/ Treas. Reg. §31 . 6001-1 (e ) .

16^/ §964(c) (1) .

17 / Treas. Reg. §1.964-3(a).

1^/ Treas. Reg. §1.964-3(b).

1^/ §6653{a).

20 / R. Simkins Estate , 37 T.C.M. 1388, DEC 35, 368 (M) T.C.
Memo 1978-338, affd., D.C. Cir. (Apr. 28, 1980), unpub-
lished opinion.

195

3. Powers to Compel Production of Books and Records

While the Internal Revenue Code gives the IRS the right
of access to taxpayer books and records, taxpayers do not
always willingly cooperate. To deal with these situations,
the IRS is given broad authority to compel the production of
books and records (and testimony) believed to be relevant.

Section 7602 of the Code provides that the IRS may
examine any books, papers, records, or other data which may
be relevant or material to determine tax liability, and may
summon or command the person liable for the tax or an officer
of the taxpayer to produce the above and to give testimony
under oath as may be relevant or material to computation of
the tax liability. Section 7602 further authorizes the IRS
to command production of books and records in the hands of a
third-party recordkeeper. A summons may be enforced by a
United States district court. ^^^ Failure to, comply with a
summons can result in a contempt citation. — '

4. Analysis

Although the IRS is statutorily granted broad access to
relevant information, significant legal and practical problems
restrict that access.

a. Legal

A taxpayer may assert legal defenses against an IRS
demand for books and records. If the taxpayer believes that
an investigation may lead to a criminal charge, he may
exercise his Constitutional privilege against self-incrim-
ination. If the books and records are in the hands of an
agent, the taxpayer may assert that they are protected by
the attorney-client privilege. The limits of these defenses
are fairly well established by case law. A taxpayer may
claim that the material summoned is irrelevant to his tax
liability, or that production of the material would be
unduly burdensome. A taxpayer may stay compliance of the
summons and intervene in a summons enforcement proceeding to
contest the production of books and records in the hands of
third-party recordkeepers. —

2_1/ §7604{b) .
22/ Id^
23/ §7609.

196

A few taxpayers have apparently taken the position that
production of books and records of their foreign subsidiary
is not required unless a subpart F issue is raised. — '
Thus, if the issue raised by the agent deals with §482,
these taxpayers argue that they are not required to produce
the records. Section 6001 does not specifically refer to
books and records of a foreign affiliate.

b. Administrative

The IRS is often subject to administrative constraints,
self-imposed and otherwise. Perceived time pressures often
encourage the closing of cases at the agent level before
access has been gained to all accountable books. Limited
resources produce a similar result.

c. Tactical

Taxpayers aware of IRS administrative constraints often
employ delaying tactics. Legal claims may be asserted for
dilatory purposes only. Because a taxpayer can stay com-
pliance with a third party summons without reason, such is
often the practice. Intervention does toll the statute of
limitations, but only from the time a Government petition in
response to a stay of compliance is filed with the district
court. Significant time lags occur between IRS receipt of a
stay of compliance and filing of a petition in response.
The IRS and Justice internal review processes are partially
responsible. Also, there are significant delays after a
proceeding is brought in a district court.

Taxpayers may employ more devious delaying tactics.
In some cases, deadlines agreed to between IRS agents and
taxpayers pass without receipt of requested and promised
information. In some cases this is due to taxpayer administrative
difficulties in complying with a request, but in others it
appears due to malice or benign neglect on the part of the
taxpayer, who believes that procrastination will cause the
IRS to lose interest in the case or to propose only poorly
developed adjustments. A survey of all International Examiners
in conjunction with this study identified a significant
number of cases where the agent believed, and appeared to
have reason to believe, that a taxpayer unnecessarily delayed
the production of requested material. A number of cases
appeared clearly abusive.

24 / In which case production is required under §964(c).

197

On the other hand, it was not our impression that most
taxpayers procrastinated. As industry groups have pointed
out, it is both time consuming and expensive for a company
to delay the conclusion of an examination. There is also
the problem of imprecise requests for information from IRS
agents. Industry groups have alleged that, in some instances,
requests for information are "nothing more than fishing
expeditions." Overly broad requests, such as requests for
"all sales invoices of a particular foreign subsidiary" or
"all communications between the foreign subsidiary and the
parent company", have been cited. There is a great deal of
reluctance to respond to such broad based inquiries, particularly
when the materials are in a foreign country and in a foreign
language.

Furthermore, in some cases cited by International
Examiners as abusive delays, a criminal investigation had
been commenced. It is unrealistic to expect that the subject
of a criminal investigation will cooperate in an investigation
which could lead to a criminal prosecution.

C. Information Gathering Abroad

Except in the case of a United States shareholder of
a controlled foreign corporation, the Internal Revenue Code
does not specifically require that books and records relevant
to tax liability , of a U.S. taxpayer be maintained in the
United States. — ' Of course, the Code cannot mandate maintenance
of books and records of third parties who are not U.S.
taxpayers, citizens, or residents. When information necessary
for an audit or investigation is unavailable in this country,
it must be sought abroad.

Information may be sought abroad unilaterally or through
bilateral or multilateral conventions to which the United
States is a party. In either case, success in obtaining
information is dependent on a number of factors. Initially,
the IRS must be aware that the information does or may
exist. While the tax and information returns previously
discussed may be useful, a taxpayer seeking to avoid or
evade tax, or to hide assets, may either fail to file the
relevant return or file a false return. A second major
factor is gaining access to the information; this depends to
a great degree on resolving conflicts between U.S. and

25/ §964{c).

198

foreign law and on the willingness of the foreign juris-
diction to cooperate. An additional factor, of primary
importance in criminal cases, is that the information must
be secured in a form admissible in a United States court of
law.

1. Unilateral Means

The United States does not have income tax treaties or
other exchange of information agreements with most tax havens.
Those in force often do not override local secrecy laws and
practices. Therefore, unilateral means to gain access to
information must be used.

a. Public Information

The extent to which useful public information is available
depends upon the country involved. In some jurisdictions
public information concerning commercial or corporate affairs
is extensive, while in others such information is extremely
limited. In jurisdictions maintaining extensive public
records, an "impartial observer" seeking, for example,
information concerning the business and financial affairs of
a foreign corporation, might expect to find a copy of a
corporate charter, corporate financial statements, a statement
of corporate business affairs, corporate earnings statements,
and perhaps even the identify of the corporate board of
directors or similar body, and principal officers and shareholders,
However, even where useful information is publicly available,
some jurisdictions view access to it in the course of an
official IRS examination as a breach of sovereignty which
requires permission of the foreign government before information
gathering may commence. As part of this study, the Office
of International Operations (OIO) compiled a description of
publicly available information in over 30 tax haven juris-
dictions.

Even where public records are available and the local
government does not unduly restrict IRS activities in obtaining
them, the legal use of nominees or bearer shares which
conceal the identity of persons involved with the corporation
will close off investigative leads. OIO advises that use of
nominees is common in tax haven countries such as the Bahamas,
the Cayman Islands, and Panama.

An example of a tax haven country maintaining extensive
public records is Switzerland. Switzerland requires that
corporations publish extensive corporate and finanacial
data. Under Swiss law, every business enterprise is required
to file certain basic information in the register of commerce

199

located in the Canton where its principal place of business
is situated. Information required to be filed includes: a
copy of the statute (charter) of the enterprise, including
its name, purpose and address of registered seat; the names
and nationalities of directors or managers; the names of the
founder or partners, and the extent of their contributions,
liabilities and preferential rights; the amount of authorized
and paid-in share capital; the names and powers of persons
authorized to sign on behalf of the enterprise; and the way
in which official notices are to be published. Changes with
respect to any of the required information must also be
published.

Notwithstanding the extensive amount of information
required to be made public, the identity of owners of a
Swiss entity can easily be hidden. It is common practice
for those wishing to conceal their business affairs to use
either nominees or bearer shares to do so. In addition,
holding companies may appoint the office of a local bank, a
lawyer, or a chartered accountant as their local office in
order to further conceal corporate affairs.

Information gathering in Switzerland is severely re-
stricted by both Swiss law and Swiss Government policy.
Swiss approval must be obtained before any information
gathering is conducted in Switzerland. Several articles of
the Swiss Penal Code, the violation of which would subject
an IRS agent to imprisonment, apply to unauthorized information
gathering in Switzerland, even for an official IRS investigation.

In contrast to Switzerland, the Cayman Islands government
prohibits extensive public records with respect to corporations.
The Confidential Relationships (Preservation) Law prohibits
the disclosure of any corporate information other than the
name of the corporation, date of incorporation, and registered
office for the corporation. The registered office is usually
the office of a law firm or trust company, which also is
prohibited by the law from disclosing information. No
commercial register is maintained on the Cayman Islands, and
disclosure of court records is prohibited to the extent that
they involve matters covered by the confidentiality laws. A
limited procedure for obtaining some information subject to
the confidentiality laws is available, in the case of crimes
occuring within the United States involving financial transactions
in the Cayman Islands.

Even this limited exception does not apply in the case
of tax crimes. Moreover, any information gathered in the
Cayman Islands, including public information, is subject to
clearance by the United States Consul and permission of the
Cayman Government.

200

Even in those instances where useful public information
can be obtained, practical problems may arise which render
such information useless for tax purposes. For example, in
conducting a net worth investigation of a taxpayer, a special
agent may discover that the taxpayer is secreting money into
the Cayman Islands to purchase real estate there. Although
the Cayman Islands maintains public records of real estate
transactions, this information is not indexed in an alphabetical
file. To obtain land records, it is necessary to know the
legal description of the property. In those cases where such
information is not available, and where the taxpayer refuses
to cooperate or exercises his right against self-incrimination,
it is impossible to confirm ownership absent an independent
source.

b. Overseas Examination

If, during an audit or investigation, it becomes necessary
to examine the taxpayer's books and records located outside
the territorial jurisdiction of the United States, the IRS
may request the taxpayer's permission to conduct an overseas
audit or on-site examination. In criminal cases taxpayers
obviously will not cooperate. If permission is granted, the
IRS may have one of its overseas Revenue Service Representatives
(RSRs) perform the task. In the alternative, the agent
assigned to the case in the United States may be authorized
to travel abroad. Either alternative has drawbacks. Travel
funds and time involved in sending a U.S. based agent abroad
can be substantial. Use of an RSR can limit the cost, and
the RSRs have been very helpful in obtaining specific
information. The RSR may not, however, have the background
in the matter to know when to follow up on specific requests.

In many instances an on-site examination may not be the
most efficient use of resources. For example, if the IRS is
trying to corroborate a deduction, the records might be more
appropriately produced here or the deduction denied.

Where an on-site examination appears desirable, the IRS
is generally required to secure .permission of the local
government before proceeding. — ' Governmental permission is
likewise generally needed prior to interviewing a person in
a foreign country relative to an IRS investigation. The
necessity for obtaining both taxpayer and local government
permission to make an on-site examination severely limits
its utility. The IRS has experienced situations in which an
on-site audit was successful in one year, and permission was
then denied in the next year, either by the taxpayer or the
local government.

26/ See infra at C.l.a. of this Chapter re Switzerland.

201

c. Compulsory Process

If the taxpayer is unwilling to permit an on-site
examination of books and records located outside the United
States, or if the books and records are those of a third
party, the IRS may resort to compulsory process. This can
take the form of an administrative summons, a judicial
subpoena, or, when requesting that a foreign juridiction
exercise its compulsory process for the benefit of the IRS,
letters rogatory.

(i) Administrative summons . The IRS has been successful
in obtaining access to books and records, physically located
in a foreign jurisdiction, through the issuance of an adminis-
trative summons, at least where those documents are under
the custody or control of an entity or person controlled by
a U.S. person. In addition to the defenses (discussed in
P. 4. a. of this chapter) which a taxpayer or third party i
record keeper has to the production of books and records in
response to an administrative summons, the defense often
encountered here is that a foreign law or rule of law imposing
civil or criminal liability prohibits the taxpayer or third
party from producing the documents requested. By definition,
this will generally be the case where the documents to be
produced are located in a tax haven jurisdiction.

As a general proposition, the courts of this country
will not require a person to perform an act in this country
which would violate foreign law. — ''^ Some courts have balanced
the IRS interest in obtaining the documents or testimony
requested against the foreiqnp'50v^J^'^rnent ' s interests in
maintaining its rule of law. — ^ Thus, cases are decided on
an ad hoc basis, the outcome depending on the unique facts
involved in each (e.g., the type of foreign law involved,
the identity of the person being requested to produce).
Some relevant factors are illustrated by the following
hypothetical examples, based, in part, on actual cases.

In an investigation of a United States-based multinational
corporation, a special agent believes that a Swiss bank
account, maintained by a wholly owned subsidiary of the U.S.
parent, was used by the foreign subsidiary to make an illegal

27 / United States v. First National City Rank , 396 F. 2d
897 (2d Cir. 1968) .

28 / In re Westinghouse Electric Corporation Uranium

Contracts Litigation , 563 F. 2d 992 (10th Cir. 1977) ;
Restatement (Second) of the Foreign Relations Law of
the United States, §§39 and 40 (1965).

202

payment to a foreign official to effectuate a sales agreement
between the U.S. parent and the foreign official's government.
The agent further believes the payment was incorrectly
characterized and deducted on the corporate tax return. The
agent has served an administrative summons on the U.S.
parent commanding production of the subsidiary's records of
the Swiss Bank account, including copies of deposited items
to the account and checks written on the account. Upon
advice of counsel, the U.S. parent refuses to produce these
records on the basis that (a) the records are located in
Switzerland and hence not subject to the summons power, and
(b) the production of these records would violate the Swiss
bank secrecy law.

Standing alone, the fact that records are located
overseas will not deprive a United States district court of
jurisdiction to compel their produc tioDQin proceedings to
enforce an IRS administrative summons. — ' Similarly, the
argument that the U.S. parent could not produce the records
since it does not have control over them would be unavailing
because the U.S. parent is the sole shareholder of the Swiss
subsidiary and, in that capacity, would be able to exercise
its authority as shareholder to force the subsidiary to have
the records produced. — '

A different question is presented with respect to the
violation of the Swiss Bank Secrecy law. While it is generally
true that the United States courts will hesitate to require
a person to do an act in this country which would violate
foreign law, under the facts of this example a violation of
the Swiss bank secrecy law is not involved. ^- Under that law
the customer is "the master of the secret." — ' In the
summons enforcement proceeding, the court would require the
U.S. parent to exercise its control with respect to the
requested records. — '

29 / Societe Internationalee Pour Participations Industries
V. Rogers , 357 U.S. 197 (1958).

30 / Societe, supra ; First National City Bank v. Internal
Revenue Service , 271 F. 2d 616, 618 (2d Cir. 1959),
cert, denied , 361 U.S. 948 (1960).

31 / Trade Development Bank v. Continental Insurance Capital ,
469 F. 2d 35, 41 at n. 3 (2d Cir. 1972).

32 / Securities and Exchange Commission v. Minas de Artemisa ,
S.A. , 159 F. 2d 215 (9th Cir. 1945).

203

In another case, a revenue agent is examining the
income tax return of a nonresident alien, a foreign entertainer
who has earned substantial sums of money, on a concert tour
in the United States, which the entertainer claims are
exempt from U.S. income taxes by reason of an income tax
treaty. To determine the entertainer's U.S. tax liability,
the revenue agent must see several employment and royalty
agreements between the entertainer and a Grand Cayman Islands
corporation, copies of which are in the physical possession
of the Grand Caymans branch of a large international accounting
firm whose headquarters are in New York. The revenue agent
served an administrative summons on the head office of the
accounting firm in New York to obtain copies of these agreements.
Upon advice of counsel, the accounting firm refuses to turn
over the records, citing as its reason that production of
the records would violate the criminal laws of the Cayman
Islands.

Based on the authorities discussed above, the accounting
firm would be required, at a minimum, to exercise good faith
efforts to obtain the consent of the entertainer to produce
the agreements. Failing in that, it is unclear whether the
accounting firm would still be required to produce the records.—^

In another case, a special agent has under investigation
a taxpayer who is a sole shareholder of a corporation in the
manufacturing business. The special agent believes that the
taxpayer has omitted substantial amounts of income from the
corporate tax return, by deducting payments to a Bahamian
corporation for goods allegedly used in the manufacturing
process. The special agent believes that, in reality, the
Bahamian corporation is owned by the taxpayer, and that the
payments made to it are not for items purchased but are merely
a diversion of corporate receipts to a numbered bank account
in the Bahamas owned and maintained by the taxpayer. A check
of the public records in the Bahamas indicates that the
Bahamian corporation is incorporated and has its office at the
offices of an attorney in the Bahamas. In response to a
summons issued to him, the taxpayer has refused to answer any
of the special agent's questions regarding this transaction,
citing his right against self-incrimination under the Fifth
Amendment.

33 / Application of Chase Manhattan Bank , 297 F. 2d 611 (2d
Cir . 1962); Lfriited States v. Fir st~National City Bank ,
396 F. 2d 897 (2d Cir. 1962); United States v. Field ,
532 F. 2d 404 (5th Cir. 1976); cert, denied , 429 U.S.
940 (197 6); Arthur Andersen Company v. Finesilver , 546
F. 2d 338 (10th Cir. 1976), cert, denied , 429 U.S. 1096
(1977).

204

Under the facts of this example, the agent will be unable
to gain access to either the bank or corporate records needed
to complete the investigation, since there is no person subject
to the personal jurisdiction of the United States courts who
can be forced to produce these records. Thus, absent evidence
of other violations by this taxpayer, or evidence provided by
an independent source, this case cannot be forwarded for
prosecution. However, in the event that a person became subject
to the jurisdiction of the United States courts to be required
to testify, the taxpayer would be unable at trial to block such
testimony based upon the assertion of the bank secrecy law of
the Bahamas. —

Use of process has other limitations. If a United States
citizen is outside the United States, an administrative
summons apparently can be directed to him. However, IRS may
not be able to enforce that summons, since the law neglects
to specifically confer venue except when a person "resides -^z
or may be found" in a judicial district of the United States. — '
A summons cannot be served on a foreign person not present
in the United States. Accordingly, as indicated in the last
example, an administrative summons cannot be used to compel
the testimony of a Cayman bank official not present in the
United States.

(ii) Judicial subpoena . Where IRS has determined that
a particular matter should be pursued criminally, it may
seek authorization to place the investigation in the hands
of a grand jury. A grand jury investigation has the advantage
of the subpoena power, which is much faster than an administrative
summons in compelling the production of books and records
relevant to an investigation. Moreover, when IRS personnel
are assigned to assist the grand jury, they are able to
coordinate closely with law enforcement personnel from^other
agencies, a practice otherwise restricted by statute. — ^ On
the negative side, the procedures which the IRS must follow
to obtain grand jury authorization have been cumbersome and
time-consuming. At one time, approval of a request through
both IRS and the Department of Justice, which approval is
required by law, could take six months, even if the request

34/ United States v. Frank , 494 F. 2d 145 {2d Cir. 1974).

35 / §§ 7402(b) and 7604(a). See United States v. Harkins ,
581 F. 2d 431, 438 at n. 11 (5th Cir. 1978).

36/ See §6103.

205

was generated outsid^^of the IRS. Steps have been taken to
reduce this time lag — ' and, while it is too early to tell
whether they will be effective, there are indications of
improvement.

Grand jury proceedings are secret and an IRS employee
privy to information obtained by the grand jury may not
disclose it. Thus, information gathered by the grand jury
may not be used to determine civil tax liabilities, absent a
court order granted pursuant to Rule 6(e), Federal Rules of
Criminal Procedure, unless the information becomes part of
the public record. Information independently developed by
the IRS is not so restricted and may be used for civil tax
purposes. Should the IRS desire to secure grand jury material
for civil tax purposes, a request for a Rule 6{e) order can
be made only by a Justice Department attorney, not by an IRS
(Chief Counsel) attorney. The IRS interest in civil enforcement
can come into conflict with the Justice Department's overriding
interest in the criminal justice system.

The ability of a subpoena to secure books and records
physically located in a foreign jurisdiction is roughly
equivalent to that of the administrative summons. The same
legal principles apply. Unlike the summons, a subpoena
directed to a U.S. citizen situated abroad is clearly enforcable
in the United States district court from which it issues.

(iii) Letters rogatory . Where evidence located in a
foreign jurisdiction is neither in the custody of nor controlled
by a person subject to the jurisdiction of the United States
court, the IRS may seek to obtain it through letters rogatory.
In this case, letters rogatory represent the request of the
United States court (in a civil or criminal matter) for the
assistance of a foreign tribunal in obtaining evidence. The
requested assistance can range from the effecting of service
of process to the taking of testimony or the securing of
books and records. The procedure is available only in a
judicial proceeding.

Letters rogatory have been used infrequently in tax
cases (civil or criminal). The decision to grant assistance
is completely within the discretion of the foreign tribunal.
Should that tribunal decide to execute the request, the
"turn around" time is tremendous — anywhere from three
months to a year.

37/ See IRM 9267.2.

206

d. Tax Court

The United States Tax Court, at the trial stage, has
the authority to require a foreign petitioner to produce
books, records, documents or other evidence deemed necessary
to the proceeding. — If the petitioner fails or refuses to
comply after a reasonable time for compliance, the Tax
Court, upon motion, may strike the pleadings or parts thereof,
dismiss the proceeding or any part^thereof , or render judgment
by default against the petitioner. — '

These Tax Court powers are limited to those cases in
which the petitioner is a nonresident alien individual,
foreign trust or estate, or foreign corporation. Such
sanctions are not otherwise available and, therefore, cannot
be used to penalize, for example, a U.S. shareholder of a
controlled foreign corporation which fails to produce the
necessary corporate records.

e. Information Gathering Projects and Informants

The IRS has conducted information gathering projects.
Some were intended to develop institutional knowledge about
tax haven activities. Others were intended to identify tax
offenders or evaders. In criminal cases, informants have
proved valuable at times. These subjects are discussed in
Chapter VI.

2. Bilateral or Multilateral Means

Because unilateral means for obtaining information are
limited by the willingness of foreign governments to cooperate
on a case-by-case basis, and by the lack of established
channels for obtaining assistance, the United States has
entered into various bilateral and multilateral agreements
with other countries which provide both an agreement for
cooperation and a procedural framework for obtaining information
pursuant thereto. Unfortunately, with the exception of tax
treaties, these agreements have been of little use in tax adminis-
tration.

3J^/ §7456{b)
39/ Id.

207

a. Tax treaties

Tax treaties, in addition to dealing with double taxation
issues, are intended to prevent fiscal evasion. — ' United
States treaties in force contain an article obligating this
country and its treaty partner to exchange information on
matters related to tax administration. The United States
Model Income Tax Convention and the OECD Model Income Tax
Convention "exchange of information" articles provide for
exchanges of information necessary to carry out the provisions
of the convention or of, the domestic laws of the respective
contracting countries. —

Poth models contain identical limitations. The parties
need not go beyond the internal laws or administrative
practices of either party to obtain information for the
requesting country. (The OECD commentary states that a
country is obligated to make special investigations if
similar investigations would be made for its own purposes.)
Both parties must treat information received as confidential,
to be used only in tax proceedings concerning taxes covered
by the convention. A party may disseminate information only
to those involved in the collection of taxes or the enforcement
of tax laws.

The U.S. model is broader in scope than the OFCD model.
The U.S. model requires that information be provided in an
authenticated form. However, a country is required to
produce this quality of information only if permitted under
its laws and practices. It also provides for collection of
taxes if necessary to ensure that the tax benefits of the
convention do not inure to persons not entitled to the
relief provided. It further applies to taxes not covered by
the convention.

The United States has interpreted most of its treaties
as permitting three methods of providing information:

First, a routine or automatic transmittal of information,
consisting generally of lists of names of U.S. resident tax-
payers receiving passive income from sources within the
treaty partner, and notifications of changes in foreign law.

40 / The substantive provisions of income tax treaties are
discussed in Chapter VIII.

41/ Article 26, U.S. Model Income Tax Convention; Article
26, OECD Model Income Tax Convention.

208

Second, requests for specific information, which generally
are requests of the U.S. competent authority for information.
Specific requests for information also result from simultaneous
examinations of a single taxpayer coordinated with certain
treaty partners. One criterion in selecting a taxpayer for
simultaneous examination is the use of tax havens in its
operations.

Third, spontaneous exchange of information at the
discretion of the transmitting country. This exchange
occurs when an examining agent in one country discovers
information during a tax examination which suggests or
establishes noncompliance with the tax laws of a treaty
partner. This information may be provided without a specific
request.

The utility of tax treaties is presently limited. The
United States does not have tax treaties with the most
important tax haven countries (e.g., Bahamas, Bermuda,
Cayman Islands, Lichtenstein, Panama). Where the United
States does have treaties, serious technical deficiencies
with the exchange of information provisions restrict the
value thereof. The tax haven treaty partner is obligated
only to give such information as is obtainable under local
law. Thus, if the jurisdiction has a bank secrecy law, bank
account information will not be obtainable; if the jurisdiction
has a commercial secrecy law, corporate ownership and business
information will not be obtainable and, perhaps, even interviews
with residents of the jurisdiction will be prohibited. In
many tax haven jurisdictions, access to such information is
not only limited to foreign jurisdictions, but also to the
government of the jurisdiction itself.

A second deficiency with the exchange of information
provision is that under a literal reading a requested country
may not be obligated to perform actions which the requesting
country could not perform under its laws. Thus, once the
IRS has referred a matter to the Department of Justice for
possible criminal prosecution, the United States cannot
be certain that a treaty partner will secure information by
administrative process to be provided pursuant to the exchange
information provision, because the United States can no
longer use an administrative summons internally. This is,
admittedly, a literal reading of the treaty provision;
however, it is one that has been adopted in some cases. A
strict reciprocity approach contrasts sharply with the
United States position in mutual assistance treaty negotiations,
wherein this country has attempted to move away from direct
reciprocity.

209

Even where secrecy laws are not a factor, the attitude
of the treaty partner can make a significant difference.
Some countries (e.g., Canada) are more cooperative in preventing
international tax evasion and avoidance and, accordingly,
take an expansive view of the exchange of information provisions.
Other countries (e.g., Switzerland) take a very restrictive
view of the scope of the exchange of information provisions.
Attitude may or may not affect the quality of information
received from a treaty partner. In any event, it is often
of poor quality. For example, IRS receives routine information
from many treaty partners which fails to identify the par-
ticular taxpayer involved or the year in which the significant
transaction took place. The United States does not have
leverage available to encourage a treaty partner to provide
quality information. Information is rarely produced in a
form which will allow it to be introduced in court.

IRS internal policies and procedures may have further
restricted treaty effectiveness. With respect to procedure,
those requests which are made pursuant to treaty take a
substantial amount of time, upwards of a year from the
agent's preparation of a routine request until the time he
gets the information requested. The IRS internal review
process may have been partially at fault. Prior to September,
1980, a request generated by an agent was reviewed by his
group manager, reviewed through the regional level, and sent
to the competent authority, the Assistant Commissiner (Compliance),
where it is forwarded to 010 for formal processing. The procedure
has been streamlined so that the final field review is now
at the district, rather than regional, level. The request
then goes directly to 010 with copies to appropriate managers.
Information received is sent by 010 directly to the district.
If problems develop, supplemental information must also
follow this same path. The request must then be prepared
and delivered to the competent authority of the requested
country. Thereafter, IRS is dependent upon the good will of
the treaty partner to get the information within a reasonable
period of time.

b. Mutual assistance treaties

The United States has onl^/One mutual assistance treaty
in force — with Switzerland. — ^ A second, with Turkey, is
awaiting ratification by the Turkish government. The
united States has initialed treaties with Columbia and the
Netherlands, and is currently negotiating similar treaties
with a number of other governments. None of those negotiations
is with an important tax haven country. Some agreement with

42/ 2 U.S.T. 2019, TIAS 8302 (1976).

210

the Commonwealth of the Bahama Islands may soon be possible.
At one time, the Bahamian government indicated its willingness
to discuss a mutual assistance treaty. In December, 1980, a
Uhited States delegation went to the Bahamas on a fact-
finding mission, one purpose of which was to further explore
the possibility of negotiating such a treaty.

The usefulness of mutual assistance treaties with
respect to tax matters will depend on the scope of each
treaty. Experience with the Swiss treaty has not been
encouraging. First, the Swiss treaty is limited to criminal
matters. Second, it is applicable to "tax crimes" only if
the subject of the investigation is an organized crime
figure, the evidence available to the United States is
insufficient to prosecute the individual in connection with
his organized criminal activity, and the requested assistance
will substantially facilitate the successful prosecution and
imprisonment of that individual. Third, under Swiss imple-
menting legislation, the subject of the investigation can
contest the taking of authenticated testimony. If contested,
production of the testimony could be delayed for at least
one year. Understandably, the Swiss treaty has not been
useful in tax cases; the standards are too difficult to
meet.

Treaties negotiated or under negotiation since the
Swiss treaty are much broader in scope. Fiscal crimes in
general, and tax offenses in particular, are specifically
covered. Moreover, the United States negotiators have taken
the position, with a great deal of success, that criminal
tax offenses ought to be treated in a manner similar to any
other criminal offenses.

D. Options

Where books and records are not in the United States,
the IRS and the law enforcement community have special
problems. Some options to be considered to improve access
to books and records are presented below:

1. Unilateral Actions

The United States could change its regulations and laws
to make more information available, and to make it easier to
introduce evidence obtained. Some suggestions follow.

a. Asserting the taxpayer's burden of proof. In
civil cases, the burden of establishing the tax consequences
of a transaction is on the taxpayer. As discussed in Chapter
VII. A. 1., this burden should be vigorously relied upon in
appropriate cases.

211

b. Requiring that books and records be maintained

in the U.sT Consideration should be given to requiring that
books and records relevant to tax liability in the United
States be maintained within the territorial jurisdiction of
this country, in appropriate cases. The regulations under
§6001 could be amended to make clear the requirement that
revelant books and records of foreign subsidiaries of U.S.
persons must be made available to the IRS. The regulation
could provide that if the requested records are not produced
within some stated period of time (e.g., 90 days) the
taxpayer would thereafter be required to maintain the records
in the United States. In addition, records of a controlled
foreign corporation formed in or doing business in a tax
haven could be required to be kept in the United States,
unless the U.S. shareholder and the controlled foreign
corporation agree, in writing, to comply with the stated
time rule and provide any necessary waivers of foreign law
rights to withhold the records.

Similar record keeping requirements could be provided
for U.S. persons who have control over a foreign trust or an
interest in a foreign partnership. A regulations project
dealing with these issues has been established.

c. Venue where a party summoned is outside the United
States . Section 7604 could be amended to establish venue in
a particular U.S. district (e.g., the District of Columbia)
in those situations where the party summoned is subject to
the summons jurisdiction of the IRS but resides or may be
found outside the territorial jurisdiction of the United
States.

d. Admissibility of foreign business records. Once
access to books and records in a tax haven is secured, the
materials must be obtained in a form admissible in court.
Moreover, an authenticating witness is often required.
Because, in dealing with foreign jurisdictions, either or
both requirements often cannot be met, consideration should
be given to amending Rules 803 and 902 of the Federal Rules

of Evidence to provide that extrinsic evidence of authenticity
as a condition precedent to admissibility is not required
with respect to a foreign business record if (1) the record
was obtained pursuant to a treaty of the United States, (2)
authenticity of the record is attested to by the custodian,
and (3) advance notice is given to the opposing party to
provide a reasonable opportunity to investigate the authen-
ticity of the document. Requiring the above procedures to
be followed (including use of the treaty mechanism) should
insure that documents will have a high degree of reliability.

212

e. IRS review process for mutual assistance . The IRS
review process for exchange of information requests has been
streamlineti. It should be monitored to see that delays are
not occurring. If they are, consideration might be given to
further streamlining so that a group manager will have
final field review. Problems of regional or district coordi-
nation could still be handled by providing copies of
correspondence to an appropriate official.

2. Bilateral Approaches

Tax haven problems, by definition, involve a second
sovereign jurisdiction, and, also by definition, conflict
between the laws of that jurisdiction and the U.S. The best
way to overcome these problems, particularly where a possible
crime is under investigation, is to enter into bilateral agree-
ments with the tax haven.

a. Mutual assistance treaties. The U.S. should consider
expanding its effort to enter into mutual assistance treaties
under which the U.S. and its treaty partner agree to provide
assistance in criminal investigations. Every effort should

be made to cover fiscal crimes in general, and tax offenses
in particular. Tax offenses should be treated as any other
criminal offense. The persons responsible for negotiating
these treaties should coordinate with IRS, Treasury, and Tax
Division in deciding which countries should receive priority.

b. Limited tax treaties . Mutual assistance treaties
apply only to criminal matters. In addition to mutual
assistance treaties the United States might attempt to
negotiate limited tax treaties with tax haven jurisdictions,
along the lines suggested in Chapter VIII. They would
include an exchange of information article overriding bank
and commercial secrecy laws. See draft Model Exchange of
Information and Administrative Assistance, Paragraph 2, at
Appendix A to this chapter. The exchange of information
article would cover both civil and criminal tax information.

c. Bilateral exchange of information agreements .
Congress could empower the President to enter into bilateral
executive agreements with foreign jurisdictions for the
exchange of tax information. Arguably, the Internal Revenue
Code disclosure of information provision contained in §6103(k)(4)
would permit such agreements, in spirit if not literally.
Technical amendment to the disclosure provision is recommended
for the sake of clarity. In addition, the summons provisions

of the Code should be amended to permit the United States to
assist a foreign jurisdiction which is a party to such an
agreement.

213

d. Revise exchange of information article . The Treasury
Department should consider amending the model exchange of
information provision to better comport with the realities

of international evidence gathering among countries with
disparate internal legal systems. A contracting country should
be obligated to use its best efforts within the framework of
its internal system to supply information pursuant to a
treaty request. The model, by considering mutuality of
legal systems among treaty partners, inhibits this. The
model should require a requested country to use whatever
procedures it has, even if the requesting country does not
have or cannot use similar procedures. A draft model article
is attached as Appendix A to this chapter.

e. Steps to isolate abusive tax havens . While most
tax havens deny any interest in attracting tainted money,
the United States receives little or no cooperation in
penetrating bank and commercial secrecy laws for tax administration
purposes. As described in various portions of this report,

this unwillingness to cooperate creates significant, and at
times insurmountable, problems for United States tax adminis-
trators, as well as members of the law enforcement community.
At some point the United States may determine that tax
havens are a sufficiently serious problem to require drastic
steps directed towards gaining access to such information,
either through a tax convention or an executive agreement.
One such step might be to adopt legislation specifically
aimed at tax havens which do not provide information necessary
to enable the United States to administer its tax laws, as well
as its other relevant laws. Any country which refused to
provide information necessary to prove the substance of a
transaction in a United States court of law would be designated
a tax haven. Any such legislation would, of course, have to
contain appropriate relief provisions to permit U.S. taxpayers
to rearrange their affairs without adverse tax consequences.
United States taxpayers would be denied tax benefit of any
transactions with a country so designated. The purpose
would be to discourage U.S. business activity in the tax
haven.

(i) The tax imposed on amounts paid from the United
States to a foreign individual or corporation in a designated
tax haven would be increased from 30 perent to 50 percent.
This rate would be applied to interest on deposits in U.S.
banks.

(ii) The proceeds of a loan from a designated tax
haven to a U.S. person would be taxable to the recipient as
ordinary income, unless that person could prove to the
satisfaction of the Commissioner, that the loan is bona fide,
and that the borrower does not have an interest in the
lender.

214

(iii) For purposes of §902, a foreign corporation
organized in a designated tax haven would not be deemed to
have paid any foreign taxes. In addition, the income from a
designated foreign tax haven would be considered U.S. source
income, so that it would not increase the numerator of the
foreign tax credit limitation. This would effectively
prohibit excess credits from other countries to offset U.S.
taxes otherwise imposed on income from designated tax havens,
and would discourage U.S. business from establishing sub-
sidiaries in tax havens.

(iv) No deduction would be allowed for an expense or a
loss arising out of a transaction entered into, with, or by
an entity located in a designated tax haven, unless the
taxpayer could establish by clear and convincing evidence,
including records in the hands of third parties, that the
transaction had in fact taken place and did not involve a
related party. Inability to produce third party records
because of local law would preclude the deduction or other
tax effect claimed by the taxpayer.

(v) United States airlines might be prohibited from
flying to a designated tax haven, and direct flights from
the United States to or from the haven would be prohibited.

(vi) U.S. banks might be prohibited from conducting
business in a designated tax haven. In the alternative,
they may either be prohibited from making wire transfers
from the United States to a designated tax haven, or from
designated tax havens to the United States, or they may be
required to report all wire transfers between a designated
tax haven and the United States.

The following inducements might also be provided to
encourage tax havens to provide information:

(i) An exception from the foreign convention rules of
§274(a).

(ii) Technical tax administrative assistance to smaller
tax havens and potential tax havens willing to enter into
limited tax treaties, exchange of information agreements, or
mutual assistance treaties covering fiscal crimes, with the
United States. Any treaty would have to contain a meaning-
ful exchange of information article which overrides present
or later-enacted secrecy laws.

Chapter IX - Appendix A

215
Article 26
EXCHANGE OF INFORMATION AND ADMINISTFIATIVE ASSISTANCE

1. The competent author ites of the Contracting States
shall exchange such information as is necessary for carrying
out the provisions of this Convention or of the domestic
laws of the Contracting States concerning taxes covered by
the Convention insofar as the taxation thereunder is not
contrary to the convention. The exchange of information is
not restricted by Article 1 (Personal Scope). Any infor-
mation received by a Contracting State shall be treated as
secret in the same manner as information obtained under the
domestic laws of that State and shall be disclosed only to
persons or authorities (including courts and administrative
bodies) involved in the assessment or collection of, the
enforcement or prosecution in respect of, or the deter-
mination of appeals in relation to, the taxes covered by the
Convention. Such persons or authorities shall use the
information only for such purposes. They may disclose the
information in public court proceedings or in judicial
decisions .

2. The provisions of paragraph 1 shall be construed so
as to impose on a Contracting State the obligation to estab-
lish laws and administrative practices which permit disclosure
to its own competent authority of such information as is
necessary for the carrying out of the provisions of this
Convention or of the domestic laws of the Contracting States
concerning taxes covered by this Convention. The provisions
of paragraph 1 shall not be construed so as to impose on a
Contracting State the obligation:

(a) to carry out administrative measures at variance
with its laws and administrative practices;

(b) to supply information which is obtainable under
the laws or administrative practice of neither Contracting
State;

(c) to supply information which would disclose any
trade, business, industrial, commercial or professional
secret or trade process, or information, the disclosure of
which would be contrary to public policy.

3. The competent authority shall promptly comply with
a request for information, or, when appropriate, shall
transmit it to the authority having jurisdiction to do so.
The competent judicial officials and other officials of the
Cotracting State requested to provide information shall do
everything in their power to execute the request.

216

4. If information is requested by a Contracting State
in accordance with this Article, the other Contracting State
shall obain the information to which the request relates in
the same manner and to the same extent as if the tax of the
first-mentioned State were the tax of that other State and
were being imposed by that other State. If specifically
requested by the competent authority of a Contracting State,
the competent authority of the other Contracting State shall
provide information under the Article in the form of deposi-
tions of witnesses and authenticated copies of unedited
original documents (including books, papers, statements,
records, accounts, or writings), to the same extent such
depositions and documents can be obtained under the laws and
administrative practices of such other State with respect to
its own taxes.

5. Each of the Contracting States shall endeavor to
collect on behalf of the other Contracting State such amounts
as may be necessary to ensure that relief granted by the
present Convention from taxation imposed by such other
Contracting State does not enure to the benefit of persons
not entitled thereto.

6. Paragraph 5 of this Article shall not impose upon
either of the Contracting States the obligation to carry out
administrative measures which are of a different nature from
those used in the collection of its own tax, or which would
be contrary to its sovereignty, security, or public policy.

7. For the purpose of this Article, this Convention
shall apply to taxes of every kind imposed by a Contracting
State.

217

X. Administration

International issues in general, and tax haven related
issues in particular, are diffused throughout IRS functions
and programs. In addition, responsibility for these issues
shifts, at the litigation stage, either to the Office of the
Chief Counsel or to the Tax Division of the Justice Department.
Moreover, other agencies may be investigating a taxpayer
with respect to the nontax aspects of a case. This is
particularly likely to occur in narcotics related investigations
and in tax shelter investigations.

A. In General

The IRS annually processes over 95 million income tax
returns, sends out more than 27 million computer notices
and conducts over two million examinations of tax returns. It
is a highly decentralized organization. In the last fiscal
year the IRS employed an average of approximately 87,000
people. Approximately 5,000 of these people work in the
National Office in Washington, D. C. The remainder are
spread throughout seven regions and 58 districts in more
than 850 offices across the country and in 15 posts abroad.

The National Office provides policy direction and
program guidance and has principal responsibility for
allocating available resources among IRS programs and among
the regions. The regional offices, under the direction of
the Regional Commissioners, perform supervisory oversight
functions with respect to the districts and service centers
within their respective regions. The District and Service
Center Directors are responsible for the conduct of the
IRS's various programs, including the audit of returns
having international and tax haven issues and the investigation
of criminal cases.

Legal assistance to the IRS is provided by the Office
of the Chief Counsel. The office is divided into Regional
and District Counsel Offices. In addition, the Tax Division
of the Department of Justice litigates tax cases, other than
in the U.S. Tax Court.

The two principal IRS functions that establish policy
and overall direction with respect to enforcement of the tax
laws as they relate to tax havens are the Examination Division,
and the Criminal Investigation Division (CID). The principal
IRS function with day-to-day involvement in the foreign
area, in support of programs developed at the policy level
is the Office of International Operations (010). A brief
description of each of these functions follows.

218

1. Examination Division

The National Office Examination Division provides
policy direction and program guidance for the examination of
returns. The General Program Branch has program responsibility
for a wide range of returns, while the Special Programs
Branch develops programs for handling special cases, including
international issues. Generally, field agents of the Examination
Division audit U.S. persons doing business abroad and
foreign subsidiaries of U.S. corporations.

The Examination Division programs that may cover tax
haven issues include the general program, the fraud program,
the coordinated examination program (which handles large
cases and includes an industrywide program), the tax shelter/
partnership program, the illegal tax protesters program, the
unreported income program and the drug and narcotics program.
The International Enforcement Program (lEP) provides specialists
to assist examination agents with the international aspects
of a case.

The lEP was part of 010 and was removed from 010 in a
reorganization in the 1960 's. This program is deployed on a
key district concept. Presently, there are approximately
200 international agents in 11 key districts and 17 groups.
The international examiners are specialized agents who
assist revenue agents in the General Program when a referral
is submitted. Most of the international examiners are
assigned to the examination of large multinational corporations.
International examiners generally do not work on tax haven
cases concerning individuals, trusts, partnerships or small
corporations.

The lEP includes a simultaneous examination program,
which coordinates joint audits of multinational companies
with certain of our treaty partners. One criterion for
selecting a taxpayer for simultaneous examination is involvement
of a tax haven. There is also an industrywide program
that gathers and exchanges information on particular industries.

2. Office of International Operations

010 was established in 1955 as a division under the
Baltimore District. On May 1, 1956, it was transferred to
the Office of Assistant Commissioner (Operations), now
Office of Assistant Commissioner (Compliance). Over the
years some organizational changes have been made to better
enable 010 to deal better with international tax matters
under its jurisdiction.

219

010 is a district type office that, because of its
unique jurisdictional base and structure, is organized
within the Office of the Assistant Commissioner (Compliance).
As in a district office, 010 has an Examination Division,
Collection Division, Criminal Investigation Division and
Taxpayer Service Division. In addition to these functions,
there are the Foreign Programs, and Tax Treaty and Technical
Services Divisions.

010 examination agents audit returns of U.S. citizens
residing abroad, foreign taxpayers (individual and corporate)
having U.S. source income and returns filed by persons
required to withhold tax on income paid to foreign persons.
It conducts coordinated examinations of large foreign corporations
and, on request from the field, it conducts support examinations
of overseas subsidiaries of U.S. -based multinational corporations.
It also examines estate and gift tax returns of both nonresident
U.S. citizens and aliens. Groups of field agents specialize
in foreign entertainers, athletes, banks and insurance
companies.

010 operates as a service organization for all 58
districts in securing information from foreign countries to
the extent that the districts bring these matters to the
attention of 010. The Foreign Programs Division assists in
the performance of functions under tax treaties, principally
involving specific requests under the exchange of information
provisions. The Division also coordinates and controls
foreign travel of IRS employees and generally assists
employees in the execution of assigned duties performed
overseas.

The IRS has 15 foreign posts organized under the Foreign
Programs Division, including a post in the Bahamas. The
foreign activities of 010 are carried out by Revenue Service
Representatives (RSR's) located at the foreign posts. They
perform examination and collection functions directly and
also pursuant to collateral requests from other IRS offices.
On request of a district, they may obtain information in
connection with a district criminal investigation. They
hold conferences abroad for the Appeals Office, and assist
in settling administratively with foreign counterparts any
international tax disputes that arise under Competent Authority
provisions of tax treaties.

The Tax Treaty and Technical Services Division accumu-
lates and analyzes information concerning foreign tax laws
and U.S. tax treaties. It also has responsibility for the
preparation and negotiation of Competent Authority cases.

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3. Criminal Investigations

The Criminal Investigation Division (CID) generally
deals with fraud investigations of U.S. residents and citizens,
including citizens residing abroad and nonresident aliens
that are subject to U.S. filing requirements. The National
Office CID assists field CID offices in special inquiries
and assists in securing available information from foreign
countries and U.S. possessions relating to tax matters under
joint investigation.

The Criminal Investigation Division oversees 2,800
special agents that enforce the criminal statutes applicable
to the tax laws. Special agents receive specialized professional
training at the Federal Law Enforcement Training Center
operated by the Department of Treasury. The special agents
investigate criminal violations of the tax laws in joint
investigations with revenue agents. They also participate
in joint investigations with other agencies, often in a
grand jury. The tax crimes investigated include bribes,
kickbacks, laundered money and hidden deposits.

Special agents are located in each of the 58 IRS dis-
trict offices throughout the country. Within each district,
a Criminal Investigation Division is responsible for investigations
within its area. 010 also has a Criminal Investigation
Division which may investigate alleged criminal violations
by taxpayers under 010 jurisdiction. Seven Assistant Regional
Commissioners (Criminal Investigation) work functionally
with the Office of the Director of CID in the National
Office.

The criminal narcotics effort of the IRS is undertaken
by CID and is coordinated in the National Office in the
Special Enforcement Program by the High Level Drug Dealers
Project, which focuses on major drug traffickers. The IRS
has investigated some 1,200 cases since the inception of the
project in July of 1976 and currently has under active
investigation over 400 alleged drug traffickers. The IRS is
also currently participating in 14 strike forces, in connection
with which it is investigating some 270 organized crime
cases.

Few of these cases (less than 10) involve narcotics.
IRS management intends to increase the narcotics-related
effort. In fiscal year 1981, it is estimated that 15 percent
of CID's direct investigation time will be devoted to narcotics-
related investigations.

221

In order to develop high quality narcotics cases
efforts are being made to improve coordination with the
Department of Justice, particularly the Controlled Substances
Unit under the direction of the U.S. Attorneys, and the cash
flow projects. Further efforts at better coordination with the
Drug Enforcement Administration (DEA) are proceeding and
investigations of leads supplied by the DEA are being stepped-
up. It is too early to determine how many of these will
result in prosecutions that involve the use of offshore tax
havens.

The IRS is also increasing its efforts to identify
potential criminal investigation tacgets. Additional work
is being done to increase the utilization of the currency
transaction reports (Form 4790) in cooperation with the
Customs Service. The IRS has also placed one full-time
agent at the El Paso Intelligence Center (EPIC) run by DEA.
EPIC is a computerized data base with numerous participating
federal and state agencies of which DEA is the leading
agency. EPIC is used for the detection, interdiction and
investigation of narcotics trafficking and financing. It is
hoped that placing an agent there will help the IRS to
identify high level drug traffickers and those helping them
to conduct their finances.

4. Office of the Chief Counsel

The Office of the Chief Counsel is organized in regions
and districts parallel to the IRS field structure. In the
National Office there are various divisions, including a
Criminal Tax Division, a General Litigation Division, a Tax
Litigation Division, an Interpretative Division, a legislation
and Regulations Division and a Disclosure Division. Much
of the attorney time is spent in preparing, reviewing and
assisting in the development of substantive and procedural
guidance, including tax regulations, revenue rulings and
decisions to litigate.

There are also seven Regional Counsel and 45 District
Counsel. Most of the attorneys in the District Counsel
offices are engaged in tax court litigation; others advise
Justice attorneys on various matters, including summons
enforcement. One of the District Counsel offices services
010.

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B. Analysis

The international examiners and the 010 agents are the
IRS's international tax audit experts. Therefore, the
manner in which they are trained and deployed can impact on
all international audit areas, including tax havens. The
agents in the General Program are not prohibited from exam-
ining international issues, and, in fact, there appears to
be significant international activity in the general pro-
gram.

1 . Coordination

One of the most significant problems in international
enforcement lies in achieving effective coordination between
functions. The volume of international transactions with
which the IRS must deal continues to grow. Issues become
continuously more complex. Despite the continued efforts of
management to maintain close liason and coordination in the
international area, there are delays and failures of communication.
These problems impact particularly on the ability to deal
with tax haven transactions, where the law and the schemes
change rapidly and where it is important that up-to-date
information be disseminated to the field.

Because IRS is a diverse decentralized organization, inter-
national tax matters, as any others, arise in many of the
functions. Within the Office of the Assistant Commissioner
(Compliance), international issues arise in both the international
program and the general program of the Examination Division,
in 010, in CID, and in Collection. There is an international
group in Technical. In the Chief Counsel's office, international
issues are addressed by the Legislation and Regulations
Division, by the Interpretative Division, and by the Tax
Litigation Division, as well as by District Counsel attorneys
in the course of litigation. Furthermore, the Department of
Justice Tax Division deals with international issues in its
consideration of civil and criminal cases.

The central problem is that there is no one person below
the Assistant Commissioner level with whom one can discuss
international compliance problems. For example, if it is
necessary to gather information concerning civil inter-
national activities, both 010 and the Examination Division
must be contacted.

223

The lack of centralized control also makes it difficult
to be certain that tax haven cases are being properly controlled.
For example, it is possible for 010 to refer matters to the
field without clearance from the Examination Division.
Accordingly, cases which lEP is trying to coordinate can
inadvertantly be sent to the field.

This also creates problems of dissemination of information
to the field. For example, general information that is
gathered by lEP and disseminated to its agents is not necessarily
given to 010 and CID agents. The converse is also true.

In addition, there appears to be some problem in coor-
dination between Treasury's Office of International Tax
Counsel and IRS. There is some feeling that IRS is con-
sulted only on an ad hoc basis, making coordination between
the overall needs of international tax administration and
current treaty policy difficult. In part, this may result
because of the difficulty of finding the proper person with
whom to coordinate in IRS.

Another problem of coordination that was raised numerous
times during our discussions with field agents is a perceived
lack of communication between the field and 010. The feeling
was expressed that the problems arose particularly where a
tax haven was involved. Some agents believe that their
requests were not always handled as quickly as the field
agents would have liked and that, at times, information
that may have been available was not developed and sent to
the field. The same problem was raised by attorneys in the
Tax Division.

In part, the problem may be a failure of communication.
CID agents. Examination agents, and Justice attorneys do not
fully understand the problems faced by RSRs in gathering
requested information. In part, the problem may lie in the
procedures for referrals from the field to 010. This procedure
has recently been streamlined and an option for further
streamlining is presented in Chapter IX.

Questions have been raised as to the adequacy of coordi-
nation between the IRS and other federal agencies concerned
with offshore transactions. There seems to be a high level
of coordination with respect to individual requests involv-
ing specific active cases. We are uncertain whether there
is adequate coordination at higher levels on other than an
ad hoc basis. There does not appear to be much coordination
in the way of exchange of information on offshore issues.

224

Most coordination takes place at the case investigation
level. The Examination Division, which handles civil cases,
has a central coordinator or liaison with responsibility for
funneling field agents' requests for information to other
agencies. Often, there is a liaison person at the requested
agency with whom the IRS liaison can speak. There is no
central IRS liaison for requests from other agencies. The
other agency writes to the director of the IRS district
that has audit jurisdiction over their target. The request
is then routed through that district's disclosure office to
determine whether it can be honored. There is no centralized
file of such requests.

Liaison with the Commodity Futures Trading Corporation
(CFTC) is handled separately. Commodity shelters, partic-
ularly so-called "tax straddles," have become a major problem,
and are of particular concern to the IRS and the CFTC. The
IRS has established a shelter coordinator to monitor IRS
shelter activity, including commodity shelters. Liaison
with the CFTC is maintained directly by that coordinator.
This liaison includes funneling IRS field requests to the
CFTC as well as arranging for some joint training with the
CFTC. A procedure has been established under which the
CFTC will advise IRS when it has completed an investigation,
thus IRS can conduct a tax investigation if warranted. The
CFTC, however, has rarely become involved in offshore transactions,
because it does not have jurisdiction unless the offshore
transactions are being conducted through a domestic broker.

CID has a liaison person in the National Office who
funnels requests from the field to other agencies. In CID,
however, much of the routine coordination occurs at the
field level. National office liaison is available to those
agencies that prefer to deal with the National Office. Most
agencies apparently prefer to deal directly with the field
and come to the National Office only if there is a liaison
problem. The general feeling is that the liaison works well
within the bounds set by the disclosure rules.

There are special coordination procedures with the Drug
Enforcement Administration (DEA) with respect to narcotics
investigations. CID has a separate DEA liaison person.
Most of the contact is at the local level where it can be
focused on ongoing investigations. The National Office
generally attempts to facilitate local level contacts and to
arrange for new methods of cooperation, should that be nec-
essary. In addition, approximately 32 percent of the currently
active narcotics cases are before grand juries, coordinated
by the Assistant U.S. Attorney conducting the grand jury.
Most of these grand juries involve multiagency investigations.

225

With respect to ongoing investigations of major drug
dealers and other major financial crimes, interagency coordination
can best be achieved through the grand jury. There the
U.S. Attorney can provide direction and coordinate the
efforts of the various agencies involved. It also overcomes
some of the coordination problems caused by the disclosure
rules of §6103.

At the beginning of this study some agents in the IRS
and other agencies expressed the opinion that it took too
long for IRS to approve participation in a grand jury investigation.
Steps have been taken to speed up the review process for
grand jury clearance, and most agents we talked with were
hopeful that the problem had been minimized.

There is also an interagency narcotics-oriented group
that meets to discuss general offshore problems and to
share expertise involving offshore cases.

There appears to be little routine regular coordination

at the managerial level, either in the civil cases involving

the Examination Division or in the criminal cases involving
CID.

2. Coverage of Tax Haven Cases - Availability of Expertise

Another significant problem is the lack of expert
coverage of smaller tax haven cases. During 1980, the Tax
Haven Study Group sent a questionnaire to 6,085 General
Program agents. Two thousand five hundred responded that
they had closed a case involving a foreign transaction
during the preceding 12 months. A second questionnaire
prepared in an attempt to get more detailed information on
certain specific international transactions indicated that a
significant number of these cases involved a tax haven.
This survey of the General Program indicated that agents are
raising international issues, but the survey did not attempt
to evaluate the merit, quality or development of these
issues. Nevertheless, we did note that General Program
agents, particularly those who handled smaller cases, did
not always seem to understand the international issues in
general, and the special problems of tax havens in particular.
Often, the agents did not distinguish between the lEP and
010.

226

International Enforcement Agents deal primarily with
large cases. In many districts, the international enforce-
ment program does not have the resources to handle a significantly
increased work load, which would likely result if more referrals
from the General Program were made. Furthermore, because
they have not had the opportunity to work the cases, agents
in the International Program did not appear to be knowledgeable
about tax haven-type entities commonly used by individuals,
such as trusts and partnerships. As a result, tax haven
issues often do not get adequate coverage.

In fact, the Internal Revenue Manual sets forth man-
datory requirements for selecting for audit, domestic cor- , ,
porate returns having stated international characteristics.—
However, there are no mandatory requirements for selecting
domestic individual, partnership, and fiduciary returns
indicating foreign business„transactions or interest in
foreign financial accounts.—'^ Thus, the tendency would be
for corporate rather than individual returns to be scrutinized.

During discussions with field personnel it has been
stated that there is a reluctance to examine tax returns
with international tax issues, and tax haven issues in
particular, because of the difficulty of obtaining information,
and because such cases were perceived as taking more time
than domestic cases. This perception may have been due to a
lack of understanding of the issues.

It is obvious that practitioners are aware of, and take
advantage of, both the lack of coverage and the lack of
coordination. It would appear that at least some tax
planning using tax havens for smaller taxpayers results in
transactions that are not receiving expert coverage; some of
these are the most abusive transactions.

The staff resources devoted to international issues, and
tax haven issues in particular, have not kept pace with the
growth in international business. As indicated in Chapter
III, data show that U.S. direct investment levels in foreign
corporations almost tripled from 1968 to 1978, and that
earnings increased four times. During the same period the
number of international examiners only doubled, from 94 to
192. As of the end of 1980, there were 209 international
examiners. A concomitant problem is that overall audit coverage
has not increased since 1971, and in fact has declined since
1976. In 1976 2.59 percent of relevant returns were audited,

1/ IRM 4171. 22.
2/ IRM 4171.21(1).

227

while in fiscal year 1980 only 2.12 percent were audited.
If current budget requests are not supplemented, it is
projected that coverage may drop to 1.86 percent in 1981.
This means that the IRS will not be able to do its job in
the tax haven area. More coverage is necessary and additional
resources are needed to provide that coverage.

3. Providing Technical and Legal Assistance to the Field

Adequate technical expertise is not available to the
field on a routine basis. In the course of an audit, an
agent can request technical assistance from the Assistant
Commissioner (Technical). This, however, is a formal procedure
that can require significant time. Accordingly, the
tendency is not to use it in many cases. The process is not
available to a CID agent and was never intended to be.
Furthermore, there is no central repository of knowledge on
tax haven problems. Accordingly, new developments in the
tax havens themselves, or in the use of tax havens by U.S.
persons, are not brought to the attention of agents or
others who can deal with them. Part of the problem is
coordination, which was addressed above.

Tax shelter cases that come to the attention of Technical 's
tax shelter group are an exception. If needed, a ruling can
be prepared and issued on an expedited basis.

In CID, unless there is a local agent who has gained
some expertise on offshore cases, there is no ready source
of knowledge about tax haven problems to whom a special agent
can turn for guidance.

Examination and CID agents have only limited access to
research tools and current publications. The IRS National
Office Library did not even have some of the more regularly
used tax haven publications. 010 has a library, but, as a
practical matter, it cannot be used by district agents on a
regular basis.

A related problem is the lack of expert legal assist-
ance to CID during the course of a criminal investigation.
Tax haven cases are often more complex and difficult to
develop than domestic cases. The law involving foreign
transactions and reporting requirements is among the most
complex in the Internal Revenue Code. Moreover, criminal
cases often involve violations of nontax statutes, which
can present complicated legal issues.

228

CID agents are well trained and experienced financial
investigators. They are not necessarily experts in the
technicalities of the tax law. Accordingly, considering the
complex legal issues that arise in the course of a tax
haven investigation, it would be useful if CID agents could
get legal assistance during an investigation.

It does not appear that special agents have a significant
level of legal assistance available to them during an investigation.
As a general rule, a lawyer is involved only after the
investigation is completed, and then only in the course of
review of a prosecution recommendation by the District
Counsel, Department of Justice's Tax Division, or the U.S.
Attorney. As a result, some cases are declined during the
review process because of a legal flaw that might have been
corrected had an attorney assisted during an investigation.
Alternative approaches could have been recommended, or the
case dropped before significant resources were expended.

IRS does have a procedure that permits CID to pre-refer
cases to District Counsel during an investigation. However,
it is rarely used. There are a number of reasons for this.
With respect to tax havens, a primary reason is that CID agents
believe district counsel attorneys rarely have the expertise
to help with the complicated international and criminal issues.

4. Simultaneous and Industrywide Examinations

The Simultaneous Examination Program has become an
important focus of the lEP. Basically, the program is a
coordinated exchange of information between the U.S. and one
of its treaty partners with respect to designated taxpayers.
The selection criteria and procedures for each country with
which we have a program are set forth in a manual supplement.
One of the stated objectives of the program is to improve
procedures for exchanging information to be used in examinations
of multinational companies which have intragroup transactions
that may involve tax havens.

The chief advantage of the program is that it allows
each country to see a transaction from both sides. For
example, if a foreign company is exporting goods from France
to a tax haven and then selling from the tax haven to the
U.S., the IRS, under the simultaneous program, can get from
France information regarding the sales price. Without the
simultaneous program, it is often difficult to get this
kind of information in a timely manner. The program does
appear to have limits. The tax years under audit must be
the same in each country, and as a practical matter, the

229

taxpayer must have significant international transactions of
interest to both countries. The program, by its nature, is
most useful for cases involving larger companies or cases
involving many taxpayers (such as a tax shelter case). The
program can only be used with treaty partners, and IRS will
probably not be able to arrange programs with all of them.

5. Chief Counsel

International expertise in the Chief Counsel's Office
is diffused among a number of divisions and is not avail-
able to the field on a routine basis. While there is special-
ized international expertise in the National Office, there
is little in the Regional and District Counsel offices.
Field agents often complain that they cannot get expert
legal assistance in tax haven cases. There is no formal
coordination between the international functions in the
various Chief Counsel divisions.

Some of the most difficult tax haven issues involve
international information gathering. However, there is little
international information gathering expertise in Chief Counsel
offices. Today, the Chief Counsel experts are in 010 District
Counsel. Its primary function is to service 010, which
takes up most of its time. In addition, it provides assistance
to the field upon request. However, they do not get many requests
and we have found that many field personnel are not aware of
the existence of this expertise. The Office does not have the
resources to promote itself.

C. Options

Described below are numerous options that might be
considered for changes in IRS administrative practices and
training to better deal with tax haven related problems. As
with other areas addressed in this report, it is often
difficult to separate tax haven issues from other international
issues. Accordingly, some of the options presented below
should be considered for international issues in general.

1. Improve Coordination With Respect to Tax Haven Issues
Specifically and International Issues in General

Improved coordination with respect to tax haven transactions
is needed within the IRS and in the Office of the Assistant
Commissioner (Compliance) in particular. In fact, better
coordination of international issues in general appears
warranted. Furthermore, more focused attention on tax
havens is needed.

230

The decentralization of the IRS makes coordination
particularly difficult. With respect to tax havens, there
is a threshold problem that there is no centralized group to
gather information. Consideration should be given to creating
a unit in the National Office that would coordinate Exami-
nation and 010 programs involving tax havens, keep abreast
of current tax haven planning and information, and most
importantly, disseminate this information to field personnel.
The information dissemination function and coordination
function should also include CID. This group could make
materials available to Examination and CID, provide a certain
level of expertise to the field, and keep apprised of developments
in the area. Members of the group could attend seminars and
prepare reports that would be made available to the agents.
Materials gathered at seminars could likewise be disseminated
to the field. Further, the group could coordinate with
programs, such as the tax shelter program, which include
cases that involve significant tax haven issues. The group
might also coordinate with other agencies concerned with tax
havens.

Creating such a group would, however, further fragment
the international area. The Assistant Commissioner (Compliance)
should study ways in which coordination among the various
compliance functions dealing with tax haven issues can be
improved. The goal should be to have one person in the
Assistant Commissioner's office who would be aware of the
international issues in Compliance, and who would be familiar
with tax treaties and the foreign information gathering
activities of the IRS. This person might have personnel who
would concentrate on monitoring important international
issues, gathering information, and providing guidance and
assistance to the field. Providing a central focus would
also improve coordination with other Assistant Commissioners,—^
Chief Counsel and Treasury's Office of International Tax
Counsel.

Consideration should be given to appointing an offshore
coordinator in CID. This person could disseminate tax haven
information to the field, and could act as a liaison with
other groups within IRS, Chief Counsel and other government
agencies with respect to tax haven matters.

2/ The Assistant Commissioner (Compliance), for example, is
the Competent Authority for treaty interpretation, but
the Assistant Commissioner (Technical) must concur in
interpretations.

231

010 might also explore means of improving communications
with the field and Justice's Tax Division. Any study by the
Assistant Commissioner to determine ways in which coordination
can be improved might also focus on means for improving
coordination between the overseas information gathering
functions of the IRS and the field. Seeking broad experience,
as well as foreign language skills in appropriate cases,
might be useful.

As described above, while there appears to be adequate
coordination with respect to individual cases and gathering
information in individual cases, we see inadequate coordi-
nation with respect to tax haven issues at a more strategic
level. It was our sense from visiting and discussing
problems with personnel in other agencies that it would be
useful to arrange for some meetings at a managerial level to
determine what kind of information sharing could be done.
In some respects this is happening with the ad hoc group on
narcotics. However, a high level group, focusing on more
than narcotics, might be worthwhile.

2. Increase Coverage of Tax Haven Cases

It is clear that the use of tax havens by U.S. taxpayers
is significant and is growing. There are large numbers of
cases with tax haven issues under audit in the general
program. Very few agents in the general program, however,
have the expertise to deal with complicated and unique tax
haven cases. The lEP contains Examination's international
experts, but they focus primarily on large cases. As a conse-
quence, the failure to take on smaller cases has prevented
the development of a body of expertise in the international
trust, partnership and shelter area in the field. As a result,
some tax haven cases are not being adequately developed
because most regular agents do not have the training or
experience to deal with them. Accordingly, taxpayers can
abuse the system with a good chance of success.

The lEP could be expanded to enable it to give more
assistance in smaller cases, including those of individuals
engaged in shelter or trust transactions involving tax
havens. Increased coverage would require that additional
agents be assigned to the international program. A decision
must be made by managment as to whether such an expansion
is justified if it is at the expense of audit coverage
elsewhere. Additional agents should be specifically allocated
to auditing individuals and smaller companies. This would
help to insure that smaller international cases receive
adequate attention.

232

If the lEP is expanded, consideration should be given
to mandatory requirements for selecting or referring for
audit or assistance individual, partnership and fiduciary
returns indicating international transactions involving tax
havens. Because some of the more elusive schemes involve non-
filers or returns which appear to lack audit potential, it will
often be necessary to identify the schemes and the promoters
in order to identify the tax returns.

3. Expand Training of International Examiners to Include
Noncorporate Issues and Expand Training of Agents in
the General Program

Because the International Examiners generally handle
large cases involving multinational corporations, they get
little exposure to trust or partnership issues. Their
training does not cover these issues. If it were decided
to expand the lEP as suggested above, then training should
include partnerships and trusts.

At times, it appears that agents are not thoroughly
familiar with the problems faced by taxpayers in complying
with requests for information. Misunderstandings and unnec-
essary confrontation can result. In addition, today most
training is done by the IRS's own agents who, because they
are dealing with prior years' tax returns, may not be completely
aware of the most recent developments.

To correct this situation, arrangements could be made
to hold short training sessions conducted by outside persons.
Outside experts could give agents valuable insight into the
methods businesses follows in operating. For example, the
Federal Bureau of Investigation has a program under which
financial experts from the Wharton School of Business teach
courses in international banking. They have found this
extremely useful in helping their agents to deal with bank
fraud cases.

Tax haven awareness training, as well as some general inter-
national training, should be given to agents in the general
program. Today, many agents in the regular program are not
aware of tax haven problems. They do not realize, for
example, that transactions involving the Turks and Caicos
Islands or Belize are potentially questionable. General
training does not make them aware of these kinds of issues,
nor does it make them familiar with foreign trusts, foreign
bank accounts or other foreign transactions.

233

It would appear that the level of international activ-
ities in the general program is high enough that some aware-
ness training, as well as some basic training, could be
provided. We would suggest that any awareness training and
general international training describe the lEP and 010, and
the referral procedures to each. We found significant
confusion among agents as to the distinction between the two
programs.

Furthermore, training could give some guidance on
dealing with dilatory tactics of taxpayers. Some taxpayers
employ delaying tactics when dealing with an IRS agent,
particularly where tax haven issues are involved. It is not
clear how widespread this problem is, but it clearly exists.
In many cases agents are not prepared to deal with these
tactics. Agents should be schooled in the basic principle
that if the taxpayer fails to corroborate a deduction, the
deduction can be denied without the IRS having to go through
unreasonable attempts to obtain records. Techniques for
setting up §482 adjustments and for denying deemed paid
credits where adequate information is not made available
could also be taught.

4. Provide Additional Technical and Legal Expertise to
the Field

There is clearly a need to provide the field with
additional technical expertise. Establishing a tax haven
coordinator or group within Compliance might help as might
appointing an offshore expert in CID.

Another option that should be considered is to make
legal assistance available to agents, particularly CID
agents, during the course of an investigation. While adoption
of this option would require expenditure of resources, this
guidance might replace District Counsel post-investigation
review in offshore cases, and thus save the attorney time
expended in performing that review. In addition, it would
enable District Counsel attorneys to gain much needed experience
in both international and criminal issues.

5. Expansion of the Simultaneous Examination Program
and the Industrywide Exchange of Information Programs

The Simultaneous Examination Program has already proved
useful in dealing with tax haven related cases. It has the
potential to be one of the most useful programs for auditing
tax haven cases. At the same time, however, it also has the
potential to be costly from the point of view of National Office
management time. The industrywide program appears to be

234

developing useful knowledge concerning the tax haven operation
of a few industries. Consideration should be given to
expanding these programs, both by adding additional treaty
partners, and by increasing the number of cases under simultaneous
examination. This expansion must be coupled, however, with
careful monitoring to insure that the program does not grow
beyond a useful level, that the best cases are being identified,
and that the U.S. is getting its share of the benefits.

6. Chief Counsel

Consideration should be given to designating a National
Office attorney as the international evidence gathering
expert for Chief Counsel.

As described in Chapter IX, international information
gathering is complicated, time consuming and presents
unique legal issues. The necessary expertise can only be
acquired by seeing a large number of problems. A person who
is the focal point for all Chief Counsel information gathering
problems would eventually develop that expertise.

This expertise could best be developed and made avail-
able to the field by designating one National Office Chief
Counsel lawyer as the internal information gathering expert.
This person's primary function would be to give guidance to
field personnel with international information gathering
problems. He could visit district offices in order to make
them aware of the availability of his services. In the
alternative, this function could be left in 010 District
Counsel, but with additional resources so that they could
devote more time to educating other district counsel and the
field as to the availability of their expertise and to
following up on cases to further develop the expertise.

An advantage to keeping the function in 010 District
Counsel is that a number of attorneys, including a career-
oriented District Counsel, would gain expertise. There is
less chance that the expertise would be lost if one attorney
left an office. On the other hand, a National Office person
would be able to focus more clearly on providing a service
to the field, because that would be his sole function. The
010 District Counsel office also services 010 and the same
focus is accordingly not as easy to develop.

The Justice Department has, in its Criminal Division,
an Office of International Affairs that provides such
expertise to that department. Their Tax Division has recently
designated one of its attorneys as its international infor-
mation gathering expert. A Chief Counsel expert could
develop contacts in that and other Federal offices concerned
with similar problems.

235

Further, consideration should be given to designating
one attorney in each of certain key districts as the inter-
national expert for the region or for a number of districts.
An international expert could assist agents in Examination
and CID when they are faced with difficult technical issues
or with international information gathering problems. These
attorneys might also be available to advise or assist Chief
Counsel attorneys litigating complicated international
cases.

iUS.GOVERNMENTPRINTINGOFFICE 1981-341 544:617

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